Question

Assume that the loanable funds market for the United States is currently in equilibrium.

a) Draw a correctly labeled graph of the loanable funds market for the United States, and label the equilibrium interest rate as r* and the quantity of funds as QF*.

b) Congress has decided to dramatically cut government spending over the next two years.

i) What will be the impact of the policy action on the government's budget?

ii) On your graph in part (a), show the impact of this policy action on the interest rate and quantity of funds.

c) As a result of the government spending cuts enacted by congress, show the effects of this policy action on a correctly labeled aggregate demand and aggregate supply graph.

Answer 1

Loanable funds market for the United States is currently in equilibrium. This implies that the demand for and supply of loanable funds are equal to each other at the prevailing interest rate.

a) Below is a labelled graph of the loanable funds market for the United States, with the equilibrium interest rate shown as r* and the quantity of funds as QF*.

b) Congress has decided to dramatically cut government spending over the next two years.

i) This policy action is likely to decrease the government's budget deficit. Budget deficit is the excess of spending over revenue. Note that usually budget remains in deficit and so a reduction in spending by the government is expected to reduce the budget deficit, if revenues are not likely to increase.

ii) The impact of this policy action is shown in the graph below. The reduction in spending will increase public saving and so supply of funds will increase. Thus, the supply curve shifts to the right and this reduces the interest rate and increases the quantity of funds demanded and supplied.

c) As a result of the government spending cuts enacted by congress, the effects of this policy action on a graph of aggregate demand and aggregate supply are shown below. Due to a reduction in the rate of interest, private investment as well as consumption will increase. This increases C and I component of AD but reduces G component of AD. Overall, AD is likely to shift to the left and so price level and real GDP will fall.