Question

 5. The market for loanable funds and government pollcy

 The following graph shows the market for loanable funds. For each or 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 erect of each Individual scenario. (Note: You will not be graded on any changes you make to the graph.)

 Scenario 1: Individual Retirement Accounts (IRAs) allow people to shelter some of thelr income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.

 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 _______  investment spending to _______ .

 and the level of

 Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new copital in the relevant time period. Suppose the government implements a new investment tax credit.

 Shift the appropriate curve on the graph to reflect this change.

 The implementation of the new tax credit causes the interest rate to _______  and the level of saving to _______ .

 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 _______ , which _______  national saving.

 Scenario 3: Initially, the government's budget is balanced; then the govermment responds to the conclusion of a war by significantly reducing spending without changing taxes.

 This change in spending causes the govenment to run a budget _______ , which _______  national saving.

 Shift the appropriate curve on the graph to reflect this change.

 This causes the interest rate to _______ , _______  the level of investment spending.

Answer 1

Scenario 1

(a) Increase in maximum IRA contribution will increase savings, which will raise the supply of loanable funds (savings being source of loanable funds), shifting the supply curve to right.

(b) This change causes equilibrium interest rate to fall and level of investment spending to rise.

Scenario 2

(a) Implementation of new investment tax credit will raise business investment, increasing the demand for loanable funds (investment being the demand for loanable funds), shifting demand for loanable funds to right.

(b) New investment tax credit causes interest rate to rise and level of savings to rise.

Scenario 3

(a) A fall in military spending reduces the demand for loanable funds (since government borrowing for deficit financing purposes will fall), shifting demand 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.