Question

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1. Assume that there is no capital inflow outflow in the market for loanable funds, and that the federal government decides to increase borrowing in order to pay for some of their expenditire (i.e. G^). How would this policy change affect the market for loanable funds?

A. increase in interest rates, increase in the quanity of loanable funds

B. increase in interest rates, decreases in the quanity of loanable funds

C. decrease in interest rates, increase in the quanity of loanable funds

D. decrease in interest rates, decrease in the quanity of loanable funds

E. no change in interest rates, decrease in the quanity of loanable funds

2. Assume that there is no capital inflow or outflow in the market for loanable funds, and that the Federal Government decides to increase borrowing in order to pay for some of their expenditure (i.e. G^). Assuming that this borrowing affects capital flows between our country and Foreign Country X, how would this policy change affect our market for this other country's currency (i.e. foreign exchange)

A. increase in the price of foreign exchange, increase in the quanity of foreign exchange

B. increase in the price of foreign exchange, decrease in the quanity of foreign exchange

C. decrease in the price of foreign exchange, increase in the quanity of foreign exchange

D. decrease in the price of foreign exchange, decrease in the quanity of foreign exchange

E. no change in the price of foreign exchange, decrease in the quanity of foreign exchange

Answer 1

1. When government decides to borrow for its spending, it basically reduces public saving and hence national savings. This causes inward shift of supply of lonable funds curve (saving curve). This leads to increase in interest rates while quantity of lonable funds fall.

Option A is incorrect because lonable funds do not increase.

Option B is correct option based on above explanation

Option C is incorrect because interest rate do not fall as government spending by borrowing crowds out investment.

Option D is incorrect because there is no decrease in interest rate

Option E is incorrect cause interest rate actually changes.

2. So when government increases government spending by borrowing it reduces nation savings. The net capital outflow (or S-I line/ supply of home currency) shifts inwards as S falls. NX being unchanged, the exchange rate rises - meaning that price of foreign exchange has fallen as home currency appreciates. This appreciation has decreased net exports/net capital outflow. So quantity of foreign exhange decreases. Intuitively costlier home currency decreases exports and so quantity of foreign currency decreases.

So there is decrease in price of foreign exhange and decrease in quantity of foreign exchange. So option D is correct. Based on above discussion, other options are definetly incorrect.