Question

5. The market for loanable funds and government policy

The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each individual scenario. (Note: You will not be graded on any changes you make to the graph.)

DemandSupplyINTEREST RATE (Percent)LOANABLE FUNDS (Billions of dollars)Demand   Supply   

Scenario 1: Individual Retirement Accounts (IRAs) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.

Shift the appropriate curve on the graph to reflect this change.

This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to (fall/rise)   and the level of investment spending to (decrease/increase) .

Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit.

Shift the appropriate curve on the graph to reflect this change.

The repeal of the previously existing tax credit causes the interest rate to (fall/rise) and the level of investment to (fall/rise)   .

Scenario 3: Initially, the government's budget is balanced; then the government significantly increases spending on national defense without changing taxes.

This change in spending causes the government to run a budget (surplus/deficit) , which (increases/decreases)   national saving.

Shift the appropriate curve on the graph to reflect this change.

This causes the interest rate to (fall/rise) , (increasing/crowding out) the level of investment spending.

Answer 1

solution-

First scenario

An increase in IRAs will increase the supply of loanable funds in response to increase in savings because of increased incentive to save in the form of lower tax liability on the tax payers.

Supply curve of loanable funds will shift right or below( with demand curve remaining the same) and hence rate of interest will come down.

In response to fall in rate of interest, the investment spending will go up.

Scenario 2

Repealing of investment credit lowers the incentive in investing and hence investment spending comes down, this result in fall in demand of loanable funds with supply remaining the same. This will result in leftward or downward shift of demand curve for loanable funds. Hence rate of interest will come down and level of savings will decrease in response to lower rate of interest.

Scenario 3

In above scenario, fall in government spending results in budget surplus which increases national savings.

This incrase in savings will result in increase in supply of loanable funds i.e. supply curve of loanablefunds move rightwards or down resulting in fall in rate of interest and increase in investment spending.