Question

Assume that policymakers have proposed a decrease in retirement ages for the citizens of your country. Consider the effects of this proposed new policy.

1. Show how the change would affect supply and demand in the market for loanable funds.

2. How would this change affect the equilibrium interest rate and investment?

3. In the long run, how would this affect real GDP?

Answer 1

A decrease in retirement age of the citizens will reduce their income levels. As the income level decreases, the level of household savings of the individuals will decrease because savings are positively related to income level of individuals. This will reduce National Savings = Public Savings + Private Savings in the economy and thus supply of loanable funds will decrease. In the loanable funds market diagram below, the initial equilibrium occurs at point E1. A decrease in the level of savings will shift the supply curve leftwards to S'S' and thus equilibrium shifts from point e1 to point E2 where rate of interest in the loanable funds market increases and equilibrium level of loanable funds has decreased.

Thus, the diagram shows that equilibrium rate of interest has increased and equilibrium level of investment will decrease in the loanable funds market.

In the long run, decline in the level of investment will reduce the production capacity of the firms and this will reduce Real GDP in the economy and thus in the long run real GDP will decrease in the economy.