Question

Show the changes for each scenario on a properly drawn and labeled loanable funds market graph. Then describe what happened to real interest rates and the quantity of loanable funds. Each question is worth two points, one point for your GRAPH and one for your description of what happened.

1. The government is preparing to run a deficit in order to pay for a war.

2. Due to worries about the future, Americans significantly increase their savings.

3. A prolonged recession has prompted the government to cut taxes and increase spending.

4. America is experiencing a high rate of inflation. To fight it, the government has increased taxes and cut spending.

5. Explain what crowding out is. In which scenarios could crowding out most likely occur? Explain.

Answer 1

1. The government is preparing to run a deficit in order to pay for a war.

Solution: GRAPH 1. Real interest rates remains constant but the quantity of loanable funds increases

2. Due to worries about the future, Americans significantly increase their savings.

Solution: GRAPH 2. Real interest rates increase and quantity of loanable funds falls

3. A prolonged recession has prompted the government to cut taxes and increase spending.

Solution: GRAPH 3. Real interest rates falls and the quantity of loanable funds increases.

4. America is experiencing a high rate of inflation. To fight it, the government has increased taxes and cut spending.

Solution: GRAPH 4. Real interest rates increase and quantity of loanable funds falls