Question

In the old days, if you wanted to retire, you had to save money while you were working (or have kids, but let's just ignore that element). Let's imagine that the government decides to implement a plan whereby they take money from people who are working and give it to people who are old/retired. What effect is this likely to have in the market for loanable funds? Show on a graph. What effect would you expect this to have on the steady-state levels of capital and output. Show on another graph.

Answer 1

In the old days, if you wanted to retire, you had to save money while you were working (or have kids, but let's just ignore that element). Let's imagine that the government decides to implement a plan whereby they take money from people who are working and give it to people who are old/retired.

The market for loanable funds: When income(money) is taken from the persons earning this will take in the form of tax and hence disposable income decreases, with decrease in income there will be decrease in savings and hence the supply of loanable funds decreases. This decrease in supply of loanable funds will shift the supply curve to the left and hence at new equilibrium level e' the interest rate increases to i1 and the quantity decreases to Q1. This is shown graphically below.

The steady state level of capital is an amount of capital per worker that is stable over time - as time progresses there is no accumulation or depletion of capital. It occurs when investment in the per capita capital stock is equal to the depreciation of the capital stock. This is shown above graphically, where k* is the steady state level of capital and the corresponding output level is the steady state level of output.

But when income is taken from the earning people and given to retired people, this decreases the accumulation of capital at the same time depreciation increases. Both of these situations are unfavourable for an economy. As diversion between the two deviates the economy from the steady state level.