Question

The market for loanable funds and government policy The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each individual scenario. (Note: You will not be graded on any changes you make to the graph.) Demand Supply INTEREST RATE (Percent) LOANABLE FUNDS (Billions of dollars) Demand Supply Scenario 1: Individual Retirement Accounts (IRAs) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year. Shift the appropriate curve on the graph to reflect this change. This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to and the level of investment spending to . Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit. Shift the appropriate curve on the graph to reflect this change. The repeal of the previously existing tax credit causes the interest rate to and the level of saving to . Scenario 3: Initially, the government's budget is balanced; then the government responds to the conclusion of a war by significantly reducing defense spending without changing taxes. This change in spending causes the government to run a budget , which national saving. Shift the appropriate curve on the graph to reflect this change. This causes the interest rate to , the level of investment spending.

Answer 1

Scenario 1

(a) An increase in maximum IRA contribution will increase savings, increasing the supply of loanable funds, shifting the supply curve of loanable funds rightward.

(b) This change causes equilibrium interest rate to Decrease (Fall) and level of investment Increase (Rise).

Scenario 2

(a) Repeal of previous tax credit will decrease business investment, shifting demand for loanable funds left.

(b) New existing investment tax credit causes interest rate to Decrease (Fall) and level of saving to Decrease (Fall).

Scenario 3

(a) Fall in government spending leads to a budget surplus, which increases the supply of loanable funds, shifting supply curve for loanable funds right.

(b) This causes government to run a Budget Surplus, which Increases national saving.

(b) This causes interest rate to Decrease, Increasing investment spending.