Show the changes for each scenario on a properly drawn and labeled loanable fund

Question

Show the changes for each scenario on a properly drawn and labeled loanable funds market graph. Then describe what happened to real interest rates and the quantity of loanable funds.

1. The government is preparing to run a deficit in order to pay for a war.

2. Due to worries about the future, Americans significantly increase their savings.

3. A prolonged recession has prompted the government to cut taxes and increase spending.

4. America is experiencing a high rate of inflation. To fight it, the government has increased taxes and cut spending.

5. Explain what crowding out is. In which scenarios could crowding out most likely occur? Explain.

Explanation / Answer

1. If government is preparing to run a deficit in order to pay for a war, means government will issue bonds to finance deficits. It will increase budget deficit, increase national debt & have effect on GDP.

When government prepares for budget deficit, it means either central bank or private sector will purchase the securities issued by government. As government securities are considered safe investment there will be higher demand & the interest rate on these securities will be relatively low. This will lead to increase in money supply & puts inflationary pressure. This will increase real interest rates.

In another scenario if government borrowings are large, their will be less money available for financing private projects leading to crowing out effect. This will also raise real interest rates due to decreased quantity of loanable funds with banks.

2. Due to worries about the future, if Americans significantly increase their savings, it will lead to low interest rates & increase in the quantity of loanable funds with banks. Since people save more banks will have large amounts of savings which will force them to reduce interest rates.

3. If government cuts taxes and increase spending due to prolonged inflation it will lead to higher money supply in the economy & more purchasing power to people. It will lead to higher real interest rates & increase in quantity of loanable funds.

5. Crowding out effect: When government borrows large amounts to pay for its debt or deficits, it leads to decrease in banks reserves. There is a shortage of loanable funds with banks for private project financing & also increases the real interest rates on these funds. This phenomenon of higher government borrowing which drives away private investment due to high interest rates is called crowding out effect.

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