Question

Explain how the equilibrium real interest rate and the equilibrium quantity of credit would change in each of the following scenarios, and illustrate your answer with a well-labeled graph of the credit market.

      a.    As the real estate market recovers from the 2007 – 2009 financial crisis, households begin to buy more houses and condominiums, and apply for more mortgages to enable those purchases.

      b.    Congress agrees to a reduction in the federal deficit, which results in a significant decrease in the amount of government borrowing.

      c.    Households begin to fear that the recovery from the 2007-2009 recession will not last, and become more pessimistic about the economy.

      d.    Businesses become more optimistic about the future of the economy, and decide to distribute more of their earnings as dividends to their shareholders.

Answer 1

In following graphs, D0 and S0 are initial demand and supply curves for credit, intersecting at point A with initial interest rate r0 and quantity of credit Q0.

(a)

Increase in households buying more mortgages increases the demand for credit. Demand curve shifts rightward, increasing interest rate and increasing quantity of credit.

In following graph, increase in demand shifts D0 rightward to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of credit Q1.

(b)

A reduction in budget deficit decreases the government’s deficit financing through borrowing, which decreases the demand for credit. Demand curve shifts leftward, decreasing interest rate and decreasing quantity of credit.

In following graph, decrease in demand shifts D0 leftward to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of credit Q1.

(c)

Household pessimism decreases consumption, which increases savings, thus increasing the supply of credit. Supply curve shifts rightward, decreasing interest rate and increasing quantity of credit.

In following graph, increase in supply shifts S0 rightward to S1, intersecting D0 at point B with lower interest rate r1 and higher quantity of credit Q1.

(d)

When firms distribute more dividend, they invest less, which decreases the demand for credit. Demand curve shifts leftward, decreasing interest rate and decreasing quantity of credit

In following graph, increase in demand shifts D0 leftward to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of credit Q1.