Question

The accompanying graph shows the market for loanable funds. Using copy tools, illustrate how the market would be affected by an increase in the government's budget deficit. Label the new curve(s) appropriately. Then use the double drop line tool to plot the new equilibrium (label it E2).

PS: i dont know how to send the graph. The question has been answered before but the answer was incorrect

Answer 1

Following figure shows the Market for Loanable Funds -

As the above figure shows, initially, the market for loanable funds was in equilibrium at point E1, where demand curve for loanable funds, D1, was intersecting the supply curve of loanable funds, S1. The equilibrium interest rate is r1 and equilibrium quantity of funds exchanged is Q1.

Now, it has been stated that there is an increase in the government's budget deficit.

As government will increase its budget deficit, it will need funds to support the additional spending. For this the government will borrow from the market.

As government will increase its borrowing to bridge the increase in budget deficit, demand for loanable funds will increase.

This increase in demand for loanable funds will shift the demand curve for loanable funds to the right.

As the above figure shows, new equilibrium is attained at point E2, where new demand curve for loanable funds, D2, is intersecting the supply curve for loanable funds, S1. New equilibrium interest rate is r2 and new equilibrium quantity of funds exchanged is Q2.

Thus, increase in budget deficit has resulted in an increase in interest rate and quantity of funds exchanged.