Question

A national newspaper’s headline reads “Business Confidence Reaches Highest Level in 5 Years.”

(a) Draw a correctly labeled graph of the loanable funds market, and show the effect of high business confidence on the equilibrium real interest rate.

(b) Assume the government increases its spending on capital projects and infrastructure. Would financing the increased government spending by borrowing result in a higher, a lower, or the same equilibrium real interest rate? Explain.

(c) How will the increase in government spending financed by borrowing affect national savings?

(d) If the expected inflation rate decreases to zero, will the nominal interest rate be greater than, less than, or equal to the real interest rate? Explain.

Answer 1

(a) Draw a correctly labeled graph of the loanable funds market, and show the effect of high business confidence on the equilibrium real interest rate.

When business confidence is high, more firms borrow money for their investment projects. This leads to an increase in the demand for loanable funds. This causes the real interest rate to rise.

(b) Assume the government increases its spending on capital projects and infrastructure. Would financing the increased government spending by borrowing result in a higher, a lower, or the same equilibrium real interest rate? Explain.

If the government borrows money for its expenditure, it leads to a leftward shift in the supply of loanable funds. This leads to a higher equilibrium real interest rate.

The government saving constitutes a part of supply of loanable funds, and excessive borrowing reduces this supply. [explained further in (c)]

(c) How will the increase in government spending financed by borrowing affect national savings?

National savings = Private savings plus Public savings

If the government borrows money, it leads to a reduction in public savings. The government runs into a deficit.

This causes the supply of loanable funds to decrease.

(d) If the expected inflation rate decreases to zero, will the nominal interest rate be greater than, less than, or equal to the real interest rate? Explain.

Nominal interest rate = Real interest rate plus inflation rate

Thus, if inflation is zero,

Nominal interest rate = Real interest rate