Question

In the old days, if you wanted to retire, you had to save money while you were working (or have kids, but let's just ignore that element). Let's imagine that the government decides to implement a plan whereby they take money from people who are working and give it to people who are old/retired. What effect is this likely to have in the market for loanable funds? Show on a graph. What effect would you expect this to have on the steady-state levels of capital and output. Show on another graph.

Answer 1

Suppose, people became fearful about the future then they decided that they needed to save more because they were afraid they may lose their jobs. Another thing that might happen is, the government providing incentives to households to save more like whenever you have the opportunity like when you did in the '80s to have an individual retirement account or a 401(k) or 403 (b) these government incentives encourage people to do more savings. Now, we can talk about a third thing, which would be changed in the behavior of the government itself. Suppose the government runs a smaller deficit or a bigger surplus. That is, suppose the government reduces government spending and increases taxes, now the government is saving more money. That is, it is taking more in revenue and it is spending last so its savings is increasing. That is going to shift out the savings curve. At any given interest rate, total savings in the economy increases, anytime the government runs a bigger surplus or a smaller deficit. A fourth thing that can happen here is a change in foreign behavior. Suppose the exchange rate changes and the cost of foreigners buying stuff from our economy changes. For instance, if the U.S. dollar becomes weaker and the U.S. dollar will buy less foreign goods than before, the people from the United States are less interested in importing. When we're not interested in importing, then our trade deficit is going to shrink. Meanwhile foreigners, seeing that goods and services in the U.S. are a bargain, will start buying more stuff from us. So our exports increase our imports decrease, net exports are increasing, the trade deficit is shrinking, and foreigners are saving less money in our economy. On the other hand, if it happens in reverse, if the dollar appreciates, then we are going to find ourselves exporting less in importing more. The trade deficit increases, foreigners are lending us more money, and the savings curve shift outward at any given interest rate. So, a bigger trade deficit shifts out the savings curve. So, here is a quick summary of what can cause there to be more savings in our economy at any given real and nominal interest rate. First of all, the change and household behavior, perhaps due to incentives from the government or a fear of what can happen in the future and the desire to protect yourself with savings. Next, a change in government behavior. If the government runs a bigger surplus, it is saving more; if it runs a bigger deficit, then it is going to be reducing overall savings in the economy. Finally, a change in foreign behavior. If the trade deficit gets bigger, then foreigners are lending us more money. If our trade deficit gets smaller, then foreigners are lending us less money. So, now we have the behavior of borrowers and the behavior of lenders. We’ve got the supply curve for loanable funds and the demand curve for loanable funds. We’ve got savings and we’ve got investment. Now we're ready to put them together and find out how the change in the interest rate gives us equilibrium.