Question

Evaluate the effects of each of the following events on the market for loanable funds. Explain the effects on savings, investment, and the real interest rate.

a. Assume the next president of the U.S. is fiscally responsible and runs a government budget surplus.

b. The government decides to forgive some of the $1.53 trillion in student loan debt.

c. China decides to reduce net capital inflows into the U.S.

d. There is inflation, and the real interest falls.

Answer 1

(a)

A budget surplus decreases government borrowing for deficit financing purposes. This reduces the demand for loanable funds, shifting the demand curve leftward, which decreases real interest rate and decreases the quantity of loanable funds (savings or investment).

(b)

Waiver of student loan debt increases government budget deficit (or decreases budget surplus). This increases government borrowing for deficit financing purposes. As a result, the demand for loanable funds increases, shifting the demand curve rightward, which increases real interest rate and increases the quantity of loanable funds (savings or investment).

(c)

Lower net capital inflow in US decreases the supply of loanable funds in US, shifting the supply curve leftward, which increases real interest rate and decreases the quantity of loanable funds (savings or investment).

(d)

Decrease in real interest rate increases the quantity of loanable funds demanded (causing a downward movement along demand curve) and decreases the quantity of loanable funds supplied (causing a downward movement along supply curve). This causes a shortage of loanable funds (= quantity demanded - quantity supplied).