Use the market for loanable funds to explain what happens to 1) private savings (PS) 2) private investment spending (PI) and 3) the interest rate (r) if each of the following events occur:
Case 1: The government decides to invade and occupy a Middle Eastern nation, which causes government spending to rise.
Case 2: At any given interest rate, businesses become very optimistic about the future profitability of investment spending.
Case 3: Home prices begin declining at a rapid rate, making homeowners feel poorer. This perception causes them to spend less and save more at any interest rate than they did previously.
Case 4: The government imposes a new tax on the financial capital inflow from other nations. Because of this, the economy will have a much harder time attracting international capital.
The market for Loanable Fund :
The equilibrium in this market is determined by the demand for and supply of loanable funds. Here the savers and borrowers supply of and demand for loanable funds respectively given the rate of interest. Borrowers need loanable fund(money) to finance the investment and household save their money to earn a high rate of interest.
Answer and Explanation:
(1) When the government increases its spending then it means the employment level increases which results in a rise in the income level. The aggregate demand for the goods and services will increase which further means now the producers need to supply more goods to meet the demand. They will borrow money to buy capital goods and raw materials for the production of goods and services. The demand for the loanable fund will shift rightward causing the interest rate to rise. This will increase the cost of borrowing money hence the private investment spending will fall. At a higher rate of interest, the people will tend to save more and consume less and hence private savings increase.
2) When the business becomes very optimistic about the profitability of investment spending irrespective of the interest rate then the demand for the loanable fund will shift rightward. It will lead to a higher interest rate but private spending will continue to rise. The higher interest rate will attract the household sector to save more to earn more profit.
(3) When the home prices begin declining at a rapid rate then it makes them poorer. The perception that the value of their properties has been decreased will make them consume less and save more for the future which will shift the supply of loanable funds rightward. Private savings will increase because of the fear that their real money will fall in the future if the decline in home prices continued to be in the future. The increase in the supply of loanable funds decreases the interest rate which results in the increase in the demand for the loanable funds.
(4) When the government imposes a new tax rate on the financial capital inflow from other nations then it is very hard for an economy to attract international capital. It will result in a fall in the supply of loanable funds which raises the interest rate and hence private spending will decrease. At a higher interest rate the private savings will increase.
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from Introduction to Business: Homework Help ResourceChapter 25 / Lesson 29