Question

Let assume an economy in this year with the following loanable funds (LF) market demand equation.

Demand: r=8-0.005*QD

Where, r is the real interest rate (if r = 12 then the interest rate is 12%), QD in the quantity demanded of loanable funds (total investment). The government expenditures (G) is $300 billion, collected taxes (T) equal to $700 billion, and private saving is $800 billion.

1. Calculate the value of government savings in this economy. Is the government running a budget surplus, a budget deficit, etc.? (1 point)
2. Calculate the equilibrium interest rate r* and the equilibrium quantity of loanable funds q* in this market. (2 points)
3. Is there any future crowding effect in this economy? Explain. (1 point)
4. Assume that private saving equation is qP=400r-1,000. Find an equation for the LF market supply equation, r=a+b*QS , and (a, b) are constants to be found. (2points)

5. Graph the LF Demand and supply curves in the same diagram? Labels your diagram and show all critical points. (2 points)

6. Assume the next year the government is running a balanced budget and the economy opens to international trade. You are also told that capital outflow (NCO) is equal to $600.

1. Assume no shift on demand of LF curve. Use a supply and demand diagram of LF to analyze this policy numerically. (3 points)
2. Is this economy lending to or borrowing from foreign countries? Explain. (2 points)
3. What happen to investment and real exchange rate? Explain. (2 points)

Answer 1

a) Demand for loanable funds is equal to total investment and is given by the equation: r = 8-0.005Qd

Government expenditure, G = $300 bn

Collected Taxes, T = $700 bn

Private saving, Qp = $800 bn

a) Government saving, Qg is government income (T) minus its expenditure (G)

=> Qg = T - G = $(700-300) bn = $400 bn

Since, government saving is equal to $400 bn which is positive, government is running budget surplus.

b) At equilibrium: Demand of loanable funds = supply of loanable funds

=> Total Investment = Total Saving

Qd = Qp + Qg = $ (800 +400) bn = $1200 bn

Equilibrium Quantity of loanable funds, q* = $1200 bn

substituting the value in demand equation, we get, r* = 8- (0.005*1200) = 8-6 = 2%

Equilibrium interest rate is 2%

c) Crowding out refers to a fall in private investments when increased government expenditure leads to a rise in interest rate. Interest rates are the price of investment and when they rise, investments become expensive, and therefore, demand for loanable funds decreases leading to a fall in total investment shown by the negative sign in the demand equation for loanable funds. Since the demand for loanable funds is a function of interest rate, there will be a future crowding out. Rearranging the terms of the demand function, we see that: Qd = 1600 -200r which implies that for every 1% increase in interest rate, demand for loanable funds will go down by $200bn implying a large future crowding out effect.

d) Given Qp = 400r -1000

Qg = $400 bn

Qs = Qp + Qg = 400r -1000 +400 = -600 +400r

Qs +600 = 400 r => r = 600 +Qs)/400

=> r = 1.5 + 0.0025Qs

Therefore: a =1.5, b= 0.0025

EEquilibrium exist when Qd = Qs given by q* = 866.67 and r* = 3.67%