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Suppose that the economy begins in equilibrium in the loanable funds and goods market. Then, the...

Question:

Suppose that the economy begins in equilibrium in the loanable funds and goods market. Then, the government decides to increase its purchases without changing taxes. According to the Classical model:

a) How do the supply and demand for loanable funds in the loanable funds market shift? Draw a diagram to show what happens to interest rates and investment in the new equilibrium.

b) How do the supply and demand for goods in the goods market shift? Draw a diagram to show what happens to the interest rate and output in equilibrium.

c) In the new equilibrium, what has happened to government purchases G? To output Y? To taxes T? To consumption C? To investment I?

Macroeconomics:

Macroeconomics studies the economy at an aggregate level. It analyzes the whole economy and helps to estimate various indicators like GDP, national income, unemployment, and inflation. It is the branch of economics.

Answer and Explanation:

a) When the government increases the purchases then the money supply in the economy increases which results in a decline in the interest rate. With the declining interest rate, the demand for loanable funds in the loanable funds market increases to point F and the supply of the loanable fund's declines and shifts upwards. The economy moves from point F to point E and the equilibrium is restored. The quantity demanded and supplied of the loanable funds remains the same at Q and the interest rate increases from i to i'.

The investment declines with the rising interest rate. There is a movement along the investment curve from point A to B.

b) In the goods market, the demand curve increases with the increase in the government purchases and the equilibrium shifts from point E to F and the price level increases from P to P' and the quantity demanded and supplied also increases from Q to Q'.

The interest rate and the output increase from i to i' and Q to Q' respectively. The equilibrium moves from point A to B.

c) In the new equilibrium, the government purchases G has increased and the output has also increased. The taxes have remained the same as the government is not changing the taxes but the tax revenue has increased as the people now have more money to spend with the rising money supply. The consumption will also increase as people now have more money to spend and the investment declines as the interest rate are rising.


Learn more about this topic:

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Loanable Funds: Definition & Theory

from Introduction to Business: Homework Help Resource

Chapter 25 / Lesson 29
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