Question

Consider the following competetive economy

K=150 L=150 Production Function= Y=K^.4L^.6 Consumption Function . C=10+.7Yd I= 40-100R, G=30, T=30 .... MPL= .6K^.4L^-.4 MPK= .4K ^-.6L^.6

Find competetive EQM by leaving out goods market in your initial computations.

b) Use national savings (S) and the investment function (I) to determine the real interest rate (r). Draw the graph of the Loanable Funds Market showing the supply of loanable funds, demand for loanable funds, and the equilibrium price and quantity. (Labor Graph carefully)

Please and thank you!

Answer 1

K= 150 and L= 150

Production Function Y= K^A .4 L ^A .6 and Consumption Function C= 10+ .7d

I=40-100R, G= 30, T= 30 MPL= .6 K^A .4 L^A - .4, MPK = .4K^A - .6 L^A.

The equilibrium level of income refers to when an economy or business has an equal amount of production and market demand. The formula for the equilibrium level of income is when aggregate supply (AS) is equal to aggregate demand (AD), where AS = AD. The formula becomes Y = C + I + G, where Y is aggregate income, C is consumption, I is investment expenditure, and G is government expenditure.

C+I+G=Y

10+.7d+40-100R+30=Y

80 + .7d - 100R= Y

b) Saving function (S)= Y-C

= 80+.7d -100R - 10 -.7d

= 70 -100R

Investment Function (I) = 40-100R

S=I

Savings and investment are affected primarily by the interest rate.   Savings and interest rate is directly related and creates a positive slope because as interest rates increase, saving becomes more lucrative, so people save more. On the other hand for investment, interest rate is indirectly related and creates a negative slope, because the cost of a loan increases as interest rate increases.So for invester it is not lucrative option if interest rate is high.

Saving is a supply curve and investment is a demand curve in loanable fund market.

Loanable Funds Market:-  The loanable funds market illustrates the interaction of borrowers and savers in the economy. The market for loanable funds shows the interaction between borrowers and lenders that helps determine the market interest rate and the quantity of loanable funds exchanged.

The market for loanable funds consists of two factors, those who keep the money in a bank (savings from households like us) and those borrowing the money (firms who seek to invest the money).  Those who keeping the money are the suppliers of loanable funds, and would like to see a higher return on their savings. This means that higher interest rates are going to motivate people for their saving, or save more. There is a positive relationship (upward trend) between the loanable funds and the real interest rate for the supply of loanable funds curve.

The second relation represents those who borrowing the loanable funds.It is known  as demand for loanable funds line. People who are interested in borrowing money are more likely looking for low interest rate. Another way to think of it is to analyze how good the return on an investment will be.   If the return on your investment is 5% and the interest rate is 6%, then we won’t borrow the money. However, if my return rises to 7% then now i will make money on the deal because i am making 7% and only paying 6% to borrow the money. In that case more people will demand loanable funds at lower interest rate.

In this diagram it is shown supply of loanable line and demand for loanable line. Supply line is upward rising as rate of interest increases people will supply more funds and demand line is downward sloping because if rate of interest rate increase people will do less demand vice a versa. Equilibrium interest rate is I* and equilibrium quantity of loanable fund is Q*.