Question

What are the effects of budget deficit and budget surplus on the market for loanable funds? How are these effects called? Explain the mechanism.

Answer 1

Demand for loanable funds gives  amount of funds that firms and individuals wish to borrow at each interest rate.  

supply of loanable funds gives the amounts that individuals and government wish to save

The demand curve slopes downwards on the grounds that at a lower financing cost, firms and people can acquire funds all the more efficiently. The lower cost of credits empowers a higher amount of borrowing.

The supply curve slopes upwards on the grounds that at a higher loan cost, people get a better yield on their funds and are happy to save more.

Therefore, supply for loanable funds includes both private savings and public savings. When government spends more than it earns, it runs a budget deficit. Wheras if government reduces its spending or increases its revenue, it runs a budget surplus or a lower deficit

Deficits decrease the supply of loanable funds thereby increasing interest rate whereas surpluses increase the supply of loanable funds thereby reducing interest rates.

Budget deficit caused by an expansionary fiscal policy, is intended to increase aggregate demand. It also expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending , thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up being less powerful than was originally expected. This is referred to as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

Drop in interest rates caused by contractionary fiscal policy induces an increase investment. Lower interest rates also reduce the demand for and increase the supply of dollars, lowering the exchange rate and boosting net exports. This phenomenon is known as “crowding in.” effect