Question

Using a graph of the market for loanable funds, briefly explain the effects of each of the following on the real interest rate, saving, and investment.

(a) A decrease in the federal budget deficit.

(b) An introduction of new investment tax credit on plant and equipment.

Answer 1

(a) A decrease in the federal budget deficit will mean that the level of taxes must have increased to bring the deficit down. This will cause the disposable income of people to fall and so they demand less loanable funds. As the demand falls the interest rates fall and the demand curve shifts leftwards. The level of investment will start increasing over time as the cost of borrowing falls. The level of savings will decline as the disposable income falls and also the interest rate falls. As the economy slows down the demand for loanable funds will fall.

(b) As there is a new investment tax credit that mean that people will be willing to invest more, the demand for loanable funds rises and causes the curve to shift rightwards. Thus interest rates will increase as the demand curve shifts rightwards. As the interest rate rises the savings level will rise. In the medium term savings rises and so does investment.