Question

it is budget surplus, rather than deficit

4. Suppose the market for loanable funds is current in equilibrium, with zero capital inflows or capital outflows and zero government budget deficit. (a) Using a supply and demand diagram, depict this situation. 5 points. (b) Suppose the government begins to run a budget surplus; assuming all else equal, depict the effect this will have on the interest rates and total lending. 5 points. (c) What effect will this deficit have on the amount of lending to firms for private investment? Show the change graphically 5 points. (d) What effect will this deficit this have on long run growth in this economy? 5 points

Answer 1

Q4) a) When the market for loanable funds is in equilbrium, the demand for loanable funds is equal to the supply of loanable funds. The demand for loanable funds is based on borrowing and supply is based on savings. The interaction between demand and supply gives the real interest rate and the amount which is loaned out. Take a look at fig 1.

b) So, when government runds budget surplus, it implies that the government receives more in tax revenue than what it spends. A budget surplus increases the supply of the loanable funds, shifts the supply curve to the right, reduces the interest rate, and stimulates the investment. So, it increases the equilibrium quantity of loanable funds. So, the interest rates will reduce and total lending will increase. This is because there is surplus funds with the govt and the govt can loan this out in the loanable funds market. Take a look at fig 2.

c) So, when the government runs budget surplus, interest rates fall, so saving turns to be lesser attractive. Also, with budget surplus, the economy will most likely execute a tax cut in the future. This will make the savers think that they do not need to bother saving much anymore. So, because due to this thinking, rational private households shift their savings, it offsets the government saving. So, any change in budget surplus, will be completely offset by a corresponsing change in private savings. So, the amount by which govt budget surplus increases the supply of loanable funds, the private savings will reduce the supply by the same amount. So, equilibrium will be restored, and this budget deficit will have no effect at all on private investment. Take a look at fig 3.

Interest Rate ů Supply Scanned by TapScanner 5 E n 7 E 2 Demand tiga LF SLE Loanable Funds

d) If the government is forced to maintain a budget surplus, it will cut back on government spending and publc sector investment. Thus, it will adversely impact the long-term productive capacity of the economy. If the priority of govt. is to maintain the budget surplus, there will be lesser resources to fund productivity growth. To maintain budget surplus, the govt may need to cut spending, as it will adversely impact aggregate demand and lead to lesser growth. Budget surplus come at an opportunity cost of taking the funds from somewhere else in the economy.