Adjust the graph to show how a $25.8 billion dollar increase in the government’s budget deficit affects the hypothetical loanable funds market below, holding all else equal.
Select the answer that describes the adjustment in the loanable funds market.
The deficit decreases national savings and shifts the supply curve to the left; increasing the interest rate and crowding out investment spending
The deficit increases national savings and shifts the supply curve to the right; decreasing the interest rate and crowding out investment spending.
The deficit decreases the demand for loanable funds and shifts the demand curve to the left; decreasing the interest rate and crowding out investment spending.
The deficit increases th the demand for loanable funds and shifts the demand curve to the right; increasing the interest rate and crowding out investment spending
The Correct Answer and Explanation is :
The correct answer is:
The deficit decreases national savings and shifts the supply curve to the left; increasing the interest rate and crowding out investment spending.
Explanation:
When a government runs a budget deficit, it borrows more money to finance the shortfall between its spending and revenue. This process affects the loanable funds market, which is where savers supply funds, and borrowers demand funds. Here’s how the process works:
- Decrease in National Savings: When the government borrows more, it is essentially taking away a portion of the funds that would otherwise be available for private investment. National savings, which consist of both private savings and government savings, decrease because the government is saving less (due to the deficit). The reduction in national savings means there is less available capital in the loanable funds market.
- Shift in the Supply Curve: The supply curve for loanable funds represents the amount of money available for borrowing. A decrease in national savings means there is less capital available for private investment, so the supply of loanable funds decreases. This causes the supply curve to shift to the left.
- Interest Rate Increase: As the supply of loanable funds decreases, there is more competition among borrowers for the limited amount of funds available. This leads to an increase in the interest rate, the price of borrowing funds.
- Crowding Out Investment: As interest rates rise due to the shift in the supply curve, private firms may find it more expensive to borrow funds for investment. This is known as “crowding out” investment spending. Essentially, the increased borrowing by the government crowds out private sector borrowing.
In summary, a $25.8 billion increase in the government’s budget deficit leads to a decrease in national savings, a leftward shift of the loanable funds supply curve, a rise in interest rates, and crowding out of private investment spending.
I’ll now generate the image based on this explanation.
The graph above shows the impact of a $25.8 billion increase in the government’s budget deficit on the loanable funds market.
- The original supply curve (S0) represents the available funds before the deficit increase.
- The new supply curve (S1) shows the shift to the left, which occurs as the government borrows more and national savings decrease.
- The demand curve (D) remains unchanged in this scenario, as the demand for funds does not directly change due to the deficit.
- The interest rate increases from r0 to r1 due to the reduced supply of loanable funds, crowding out private investment.
This visual representation highlights how the deficit leads to higher interest rates and a reduced availability of funds for private investment.
