Question

Consider the economy where the demand for loanable funds from business and the supply of loanable funds from households (private savings) are:

Demand: Q=1000-100r

Supply: Q=200r-500

Q is the quantity of loanable funds and r is the interest rate. In both equations, the interest rate is expressed as a percentage (e.g. if the interest rate is 10%, then r in the equation would be 10)

Assume this is a closed economy and that the government has a balanced budget. Holding everything else constant, if the government decides to run a surplus of $600 by decreasing spending we know that:

Answer is "The equilibrium interest rate in the loanable funds market will be equal to 3% and that the level of private investment will be equal to $700."

How do you do this problem? I don't understand how they got the answer.

Answer 1

We are given the supply and demand of loanable funds from household.

Also it is given that government in order to run a surplus would reduce the spendings by$600.

If the spendings reduce, it would imply that the household would demand less.

So the new demand equation would be$600 less than the original demand.

Qd1= 1000-100r -600=400-100r

And we have the original supply equation for loanable funds.

Equating them we get the interest rate

400-100r= 200r-500

900= 300r

r=3 or 3%.

Level of private investment could be found by substituting the value of r in the original equation of demand for loanable funds

Qd= 1000-100(3)= 1000-300=$700.

(You can comment for doubts)