Question

Use the model of the market for loanable funds to predict the effects of the following events:

            a) A tax credit is given to firms starting a new business or expanding a current business.

            b) An unhealthy economy has depressed firms future profit expectations.

            c) The federal government goes from a balanced budget to a budget surplus.

Answer 1

a) A tax credit is given to firms starting a new business or expanding a current business. This leaves firms with more retained profit so investment spending is increased. Firms demand more funds so that demand for loanable funds shifts to the right. Rate of interest is increased and along with it, the quantity of funds traded.

Interest rate (i) Li L Loanable fiunds (L)

b) An unhealthy economy has depressed firms future profit expectations. Business pessimism has left firms with dismal future so that they decide to postpone the investment spending. Firms demand less funds so that demand for loanable funds shifts to the left. Rate of interest is decreased and along with it, the quantity of funds traded

Interest rate E1 rl 2 D1 Quantity of loanable funds 02 01

c) The federal government goes from a balanced budget to a budget surplus. This implies that public saving is increased and so supply of funds is increased. Supply function shifts to the right which reduces the rate of interest and increases the quantity of funds traded.

Interest rate () SS2 i2 LI L2 Loanable fiunds (L)