Question

Write out the equation for the demand and supply of loanable funds in equilibrium. Use this equation to briefly describe how changes in government budgets can affect the trade balance. Include any assumptions you make about the other components of the demand and supply of savings. Then explain the difference between a progressive tax, a proportional tax, and a regressive tax.

Answer 1

Answer)

Loanable funds means the amount of money available for borrowing. Loanable funds theory of interest was propounded by the neoclassical economists which is an improvement over the classical theory. The neoclassical economists developed the real framework which included both the real as well as monetary factors which determine rate of interest. Now, what constitutes the loanable funds:

There are four important sources of supply of loanable funds :

1. Savings ( S )
2. Bank money ( BM )
3. Dishoarding ( DH )
4. Disinvestment ( DI )

All these are interest - elastic in nature. The aggregate supply of loanable funds cure is an upward sloping curve drawn by the lateral summation of all the curves mentioned above as its sources. The positive slope of supply of loanable funds shows greater amount of loanable funds at higher rates of interest.

The Demand for loanable funds have its sources as :

1. Investment demand ( I )
2. Hoarding ( H )
3. Dissaving which means negative saving or excess of expenditure over income. ( DS )

The summation of all the three sources of demand for loanable funds will give the aggregate demand for loanable funds which is a downward sloping curve. This means that the demand for loanable funds increases as interest rate falls.

Now, the equilibrium rate of interest is determined by the intersection of demand for and supply of loanable funds.

Equating the supply of loanable funds with the demand for loanable funds , we get :

S + DH + BM + DI = I + DS + H

( S - DS ) + BM = ( I - DI ) = ( H - DH )

or Net Saving + Bank money = Net Investment + Net Hoarding

This equation tells us that the sum of net saving and bank money must equal to net investment and change in idle cash balances in a period of time for determination of equilibrium rate of interest.

The availability of loanable funds is determined by the amount of national saving which is the total income in the country. It is found out by deducting consumption and government purchases.

Now, the difference between progressive, proportional and regressive tax is enumerated below

Progressive tax means imposing large tax on high income group and low tax on low income group .

Proportional tax means applying uniform tax structure on all income groups.

Regressive tax means applying less tax on high income group and high tax on low income group.