Imagine a scenario where repeated large deficits over the years have left Debtopia struggling with massive...

Imagine a scenario where repeated large deficits over the years have left Debtopia struggling with massive amounts of debt. The President’s economic advisors are counseling her on the pros and cons of designing a budget for Congress that will have an even bigger deficit than any year before. Which of the following would have to be true for the advisors to tell the President that crowding out will NOT occur in the market for loanable funds?

Group of answer choices

The supply of loanable funds curve has to be completely elastic.

The demand for loanable funds needs to be unit elastic at equilibrium.

The demand for loanable funds curve has to be completely inelastic

The supply of loanable funds curve has to be completely inelastic

Expert Solution

So the crowding out effect is such that when government spending rises then it raises Y and this in turn raises interest rates. The rise in interest rate decreases investment spending (as I and r are inversely related) and Y falls by some amount. So the rise in G raises Y by a lower amount becasue of the crowding out of investments. So for market to not crowd out it must be the case that investments are not affected by a change in interest rate. Lets consider the options -

The supply of loanable funds curve has to be completely elastic - If this is the case then it means that a given level of interest rate, there is infinite supply of lonable funds. A rise in budget deficit reduces national savings and savings curve would shift parallaly downwards and at a lower interest rate no lonable funds would be available. This is not applicable here because crowding out effect is related to investments (lonable funds demand). Incorrect.

The demand for loanable funds needs to be unit elastic at equilibrium - This means we have a downward sloping and a rectangular hyperbolic demand curve for lonable funds. So if government budget deficit reduces savings then supply of lonable funds shifts leftwards and raises interest rates. This will cause a decrease in investment quantity and some amount of Y rise would be crowded out by fall in I. Incorrect.

The demand for loanable funds curve has to be completely inelastic is correct option. An investment demand curve which is perfectly inelastic means that there is a fixed level of investment at any level of interest rate. This means the interest sensitivity of investment is 0 and due to budget deficit and fall in savings and rise in interest rate, there will be no crowding out of investments.

The supply of loanable funds curve has to be completely inelastic - Incorrect. Crowding out effect is a demand side phenomenon. The nature of savings curve would not impact crowding out effect.

Hence third option is correct.

Rahul Sunny answered 1 year ago

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