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Higher investment spending at any given interest rate leads to an increase in the demand for loanable funds. In the accompanying figure, the increase in the demand for loanable funds shifts the demand curve from D1 to D2 and raises the equilibrium interest rate from r1 to r2.
In response to the higher interest rate, private savings will rise from Q1 to Q2. The accompanying diagram shows the market for loanable funds before the government sells the bonds. How will the equilibrium interest rate and the equilibrium quantity of loanable funds change? Is there any crowding out in the market? Since the U. This question considers the likely effect of this government expenditure on the interest rate.
Draw typical demand D1 and supply S1 curves for loanable funds without the cost of the war accounted for. Now consider a new diagram with the cost of the war included in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point E2 and the new equilibrium interest rate r2. How does the equilibrium interest rate change in response to government expendi- ture on the war? Solution 8.
The demand for loanable funds without government borrowing to finance the Iraq War is shown in the accompanying diagram. Interest rate S1 E1 r1 D1 Quantity of loanable funds b. Government borrowing to finance the Iraq War raises the interest rate in equilibri- um because the supply of loanable funds remains constant but the demand rises.
Explain why equilibrium in the loanable funds market maximizes efficiency. Solution 9. Equilibrium in the loanable funds market maximizes efficiency because it ensures that investment spending projects with higher rates of return get funded before those with lower rates of return. At the same time, private savers with the lowest opportunity cost for their funds will have their offers of loans accepted before savers with higher opportunity costs of funds.
So in equilibrium the projects with the highest rates of return will be funded by savers with the lowest costs of lending. This makes it more likely that lenders and borrowers will make mutually beneficial trades—trades that make society as a whole better off. How would you respond to a friend who claims that the government should eliminate all purchases that are financed by borrowing because such borrowing crowds out pri- vate investment spending?
You might first acknowledge that when the government runs a budget deficit, there is an increase in the demand for loanable funds. The increase in demand raises interest rates and decreases private investment spending. This means that businesses will add less physical capital each year and productivity growth may be slower than it would be if the government had not borrowed to cover its deficit. However, you might then explain that some government purchases are necessary for economic growth.
Government funds much of the infrastructure within which the economy operates for example, the legal framework, the court system, and the communications net- work , and the government also invests in education, roads, and airports necessary for economic growth. Who is better off? Solution So, in real terms, Boris pays more, and Lynn receives more, than was expected. So, in real terms, Boris pays less, and Lynn receives less, than was expected. Using the accompanying diagram, explain what will happen to the market for loan- able funds when there is a fall of 2 percentage points in the expected future inflation rate.
How will the change in the expected future inflation rate affect the equilibrium quantity of loanable funds? The real interest rate and the equilibrium quantity of loanable funds remain unchanged. The change in expected inflation causes both a downward shift of the supply curve for loanable funds, from S1 to S2, and a downward shift of the demand curve for loanable funds, from D1 to D2.
The accompanying diagram shows data for the interest rate on year eurozone gov- ernment bonds as reported by the European Central Bank and inflation for the euro- zone for through mid How would you describe the relationship between the two? How does the pattern compare to that of the United States in Figure ? The interest rate and the inflation rate moved somewhat together both moving up or down from the beginning of to the end of During , they again seem to move together.
Their sharp rise in the late s mirrors what happened in the United States during the high-technology boom, as shown in Figure But the drop in the year euro bond rate from to was not as sharp as the fall in the year Treasury rate. The pattern is similar—but not identical—to that of the United States shown in Figure Which of the following are examples of investment spending, investing in financial assets, or investing in physical assets? Rupert Moneybucks buys shares of existing Coca-Cola stock.
When Rupert Moneybucks buys shares of existing Coca-Cola stock, he is investing in a financial asset. He has a paper claim that entitles him to future income from Coca-Cola. It is not an example of investment spending because it does not add to the stock of physical capital in the economy.
It is not an example of investment spending because it does not add to the stock of physical capital in the economy—the man- sion was pre-existing. The Russian government has a paper claim on the United States that entitles it to future income. It is not an example of investment spending because it does not add to the stock of physical capital in either economy.
Explain how a well-functioning financial system increases savings and investment spending, holding the budget balance and any capital flows fixed. A well-functioning financial system increases both the supply of loanable funds and the demand for loanable funds in three ways. What are the important types of financial intermediaries in the U.
What are the primary assets of these intermediaries, and how do they facilitate investment spending and saving? Mutual funds, pension funds, life insurance companies, and banks are the most important types of financial intermediaries in the U. By either reducing risk through diversification mutual funds, pension funds , reducing risk through insurance life insurance companies , lowering transaction costs mutual funds, pension funds , or providing liquidity banks , these financial intermediaries facilitate savings and investment spending.
The interest rate on bonds falls. Several companies in the same sector announce surprisingly slow sales. It also announces that this change has no implications for future profits. Sallie Mae is a quasi-governmental agency that packages individual student loans into pools of loans and sells shares of these pools to investors as Sallie Mae bonds.
What is this process called? What effect will it have on investors compared to the situations in which they could only buy and sell individual student loans? Suppose that a very severe recession hits and, as a consequence, many graduating students cannot get jobs and default on their student loans. What effect will this have on Sallie Mae bonds?
Imports and Exports are exactly zero. Private saving is Y-T-C Public Saving is the amount of tax revenue that the government has left after paying for its spending. The government receives T in tax revenue and spends on G on goods and services. If T exceeds G the goverment has a budget surplus because it receives more money than it spends and this surplus reprents public savings. If the government spends more than it receives G is larger than T the gov.
For the economy as a whole, saving must be equal to investment. Larry's savings can be greater than his investments and he can deposit the excess in a bank. Moe's savings can be less than his investment and he can borrow the shortfall from a bank. Market for Loanable Funds: The market in which those who want to save supply funds and those who want to borrow to invest demand funds. Saving is the source of supply of loanable funds. The supply comes from people who have extra income they want to save and lend out.
This lending can occur directly when a household buys a bond from a firm or indirectly when a household makes a deposit in a bank. Investment is the source of the demand for loanable funds. It comes from households and firms who want to borrow to make investments. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. This shortage might encourage lenders to raise the interest rate they charge thus encouraging saving and increasing the quantity of loanable funds supplied and discourage borrowing for investment, thus decreasing the quantity of loanable funds demanded.
If the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders competed for the scarse borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which supply and demand are at an exact balance. One proposal is to expand eligibility for special accounts that allow people to shelter some of their savings from taxation.
The demand for loanable funds would remain the same because the tax change would not directly affect the amount that borrowers want to borrow at any given interest. The supply of loanable funds will increase. The interest rates will drop and thus will increase the quantity of loanable funds demanded. With a lower cost of borrowing, households and firms are motivated to borrow more to finance greater investment.
Thus, if a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment. Policy 2: Investment Incentives A proposal by lawmakers and economists to institute an investment tax credit which would give a tax advantage to any firm building a new factory, etc. This policy would alter investment at any given interest rate and change demand for loanable funds to a higher demand.
By contrast, because the tax credit would not affect the amount that households save at any given interest rate, it would not affect the supply of loanable funds. The increased demand for loanable funds increases raises the interest rate and the higher interest rate in turn increases the quantity of loanable funds supplied as households respond by increasing the amount they save.
If a reform of the tax laws encouraged greater investment, the result would be higher interest rate and greater saving. Policy 3: Government Beudget and Deficit and Surpluses Government finance budget deficits by borrowing in the bond market and the accumulation of past debt is called government debt. If goverment spending equals tax revenue, there is a balanced budget.
If the Gov. Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest, it does not alter the demand for loanable funds. When the gov. When the supply of loanable funds is decreased, this increases interest rate.
Many demanders of loanable funds are discouraged to invest because of the higher interest rate and fewer families buy houses and firms are discouraged from building new factories or buying new equipment. The fall in investment because of gov. When the government reduces national saving by running a budget deficit, the interest rate rises and the investment falls. Budget surpluses work the opposite way increasing the supply of loanable funds, reducing the interest rate and stimulating investment, therefore, greater capital accumulation and more rapid economic growth.
A declining debt-GDP ratio indicates that the gov. This suggest that the gov. A rising debt-GDP ratio means that the gov. The primary cause of fluctuation in gov. When war occurs gov. Taxes rise as well but much less than the increase in spending. Debt financing of war allows gov.