Question

The table sets out the data for an economy when the​government's budget is balanced.

If the​ government's budget becomes a deficit of ​$2.0 ​trillion, what are the real interest rate and​ investment?

Does crowding out​ occur?

Real interest rate ​(percent per​ year)	Loanable funds demanded	Loanable funds supplied
	​(trillions of 2009​ dollars)
4	7.5	6.5
5	7.0	7.0
6	6.5	7.5
7	6.0	8.0
8	5.5	8.5
9	5.0	9.0
10	4.5	9.5

If the​ government's budget becomes a deficit of ​$2.0 ​trillion, the real interest rate is ___?____ percent a year and the quantity of investment is ​$____?____ trillion.

​>>> Answer to 1 decimal place.

There​ _____ crowding out in this situation because​ _____.

A. ​is; the deficit increases the real interest​ rate, which decreases the quantity of loanable funds demanded

B. is​ no; investment equals the quantity of loanable funds​demanded, which means that it is not being crowded out

Answer 1

Figure 1

The demand for loanable funds in an open economy is constituted of the demand for funds from the domestic firms or investment demand and the net capital outflow of the economy. The supply of funds consists of national savings. National savings has two part one is public savings another is private savings. Private savings are the savings of the consumer of disposable income after consumption. Public savings is the budget balance of the government.

Therefore, if the budget balance of the government goes deficit from neutral, the supply of loanable funds falls by the amount of deficit at each level of interest/. Thus the new supply is old supply minus $2.0 trillion. The new supply along with the old one is given in the table below

Table 1

Real Interest rate	Loanable Funds		Loanable funds supplied after the budget deficit
	Demanded	Supplied
4	7.5	6.5	4.5
5	7	7	5
6	6.5	7.5	5.5
7	6	8	6
8	5.5	8.5	6.5
9	5	9	7
10	4.5	9.5	7.5

Therefore, after the budget deficit the equilibrium interest rate increases to 7 percent per year and the amount of loanable funds falls to $6 trillion.

The increase in budget deficit decreases the supply of loan. The firms in order to get a loan bid up to the interest rate, the rise in interest rate curbed the private investment. This is called the crowding out effect. The government spending crowds out private investment spending.

Therefore, the correct option is: (A)