Question

How would each of the following scenarios, using supply and demand of analysis to predict the resulting changes in the real interest rates, national saving, and investment. Show your answers graphically and briefly explain. 

An increase in military spending moves the government’s budget from surplus into deficit.

B.Concerns over job security raises precautionary saving.

C.New computer-controlled machines are able to produce manufactured goods more efficiently and with fewer defects.

D.New environmental regulations increase firms’ costs of operating capital.

E.The legislature passes a 20 percent investment tax credits.

 

Answer 1

In each graph, D0 and S0 are the initial demand and supply curves for loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds Q0. The loanable funds constitute either investments or national savings.

A. An increase in military spending moves the government’s budget from surplus into deficit: This increases the demand for loanable funds as government borrows money for deficit financing. The demand curve shifts right and the rate of interest rises to r1, national saving and investment rises to q1.

B.Concerns over job security raises precautionary saving: Increase in saving shifts the supply of loanable funds curve to right. The rate of interest falls to r1 and national saving and investment rises to q1.

C.New computer-controlled machines are able to produce manufactured goods more efficiently and with fewer defects: improvements in technology increase the demand for loanable funds for further investments. The demand curve shifts right and rate of interest rises to r1, national saving and investment rises to q1.

D.New environmental regulations increase firms’ costs of operating capital: Increase in firms costs increases the demand for loanable funds. The demand curve shifts right and rate of interest rises to r1, national saving and investment rises to q1.

E.The legislature passes a 20 percent investment tax credits: investment tax credits act as an incentive to increase investments. Thus the demand for loanable funds increases and demand curve shifts right. The rate of interest rises to r1, national saving and investment rises to q1.