Question

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.) Created with Raphaël 2.1.2DemandSupplyINTEREST RATE (Percent)LOANABLE FUNDS (Billions of dollars)Demand   Supply    Created with Raphaël 2.1.2 Scenario 1: Suppose savers either buy bonds or make deposits in savings accounts at banks. Initially, the interest income earned on bonds or deposits is taxed at a rate of 20%. Now suppose there is a decrease in the tax rate on interest income, from 20% to 15%. 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 selector 1    fall rise and the level of investment spending to selector 2    decrease increase . Points: Close Explanation Explanation: 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 selector 1    fall rise and the level of investment to selector 2    fall rise . Points: Close Explanation Explanation: 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 selector 1    deficit surplus , which selector 2    increases decreases national saving. Points: Shift the appropriate curve on the graph to reflect this change. This causes the interest rate to selector 1    fall rise , selector 2    crowding out increasing the level of investment spending.

Answer 1

Scenario 1

(a) Decrease in tax on interest income will increase savings, which will increase the supply of loanable funds, shifting the supply curve of loanable funds rightward.

(b) This change in tax treatment causes equilibrium interest rate to fall and level of investment spending to increase.

Scenario 2

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

(b) Repeal of investment tax credit causes interest rate to fall and level of investment to fall.

Scenario 3

(a) Lower military spending decreases the demand for loanable funds (since budget deficit falls, government borrowing falls since deficit financing requirement falls), shifting demand curve for loanable funds to left.

(b) This causes government to run a Budget surplus which increases national saving.

(b) This causes interest rate to fall, increasing investment spending.