Question

5

a. Economists often say it would be good for the US to have a higher savings rate. Explain verbally, with the aid of a graph of the loanable funds market, how a higher savings rate could be good for the economy.

b. Economists and financial analysts closely watch the “consumer confidence” index, which indicates consumers’ willingness to borrow money for big-ticket purchases like cars, houses, and household appliances. Explain verbally, with the aid of a graph of the loanable funds market, how increased consumer confidence could be good for the economy.

Answer 1

In each graph, D0 and S0 are initial demand and supply curves for loanable funds, intersecting at point A with initial interest rate r0 and initial quantity of loanable funds Q0.

(a)

Higher savings rate will increase savings in the economy, shifting supply curve of loanable funds rightwards, lowering interest rate and increasing the quantity of loanable funds. Lower interest rate boosts investment demand, thus increasing aggregate demand, which in turn increases real GDP, causing the economy to grow.

In following graph, as savings increase, S0 shifts right to S1, intersecting D0 at point B with lower interest rate r1 and higher quantity of loanable funds Q1.

(b)

Increased consumer confidence will increase the portion of consumption expenditure that is funded by borrowing. This will increase the demand for loanable funds, shifting demand curve rightward, increasing interest rate and increasing quantity of loanable funds. Though higher interest rate will dampen investment demand and lower aggregate demand, if the increase in aggregate demand caused by higher consumption funded by borrowing is greater in magnitude than the decrease in aggregate demand caused by lower investment, the net effect will be an increase in aggregate demand, which will increase real GDP.

In following graph, as demand for borrowing increases, D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds Q1.