Use the loanable funds market to graphically analyze what happens to real interest rate and investment...

Use the loanable funds market to graphically analyze what happens to real interest rate and investment if government increases its spending. Also explain what is the crowding out effects

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Expert Solution

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Question:

Answer:

If government increases its spending its increase fiscal deficit (government revenue - government spending). When the government increase spending more than its revenue then its increase fiscal deficit. So, to finance it spending, the government borrow money from the market. The government issues (sells) securities (bonds) in the open market and raise money. When the government increase borrowing then its increase demand for loanable fund. When demand for loanable fund increase, its increase interest rate.

Graphical representation:

Increasing demand for loan shift demand curve right from D to D1 that increase interest rate (real interest rate) from r to r1.

Graph:

Crowding out effects:

Increasing interest rate due to borrowing money by the government, decrease private investment spending, called crowding out effects.

Thanks

Rahul Sunny answered 1 year ago

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