Consider the information in the Loanable Funds Graph and assume that the expecte

Question

Consider the information in the Loanable Funds Graph and assume that the expected rate of inflation is 2%. The demand for loanable funds in the graph consists of the demand by households and firms. The government is not borrowing any money, because its tax revenue is sufficient to finance its expenditures.

Now a war breaks out and to finance the purchase of additional military equipment the government has to borrow in the loanable funds market. So it comes to the loanable funds market and borrows $1,600 to finance the war effort. The government's borrowing decision is not affected by the real interest rate. So demand for loanable funds increases by $1,600 at every value of the real interest rate.

The new equilibrium real interest rate will be ___ percent?

b) Consider the information in the Loanable Funds Graph and assume that the expected rate of inflation is 2%. Forget about about the increased demand by the government. This time assume that due to a credit crunch the supply of loanable funds decreases by $1,600. As a result the equilibrium real interest rate increases to ____ percent.

The following graph shows the demand for and supply of loanable funds. Borrowers and lenders expect 2% inflation down the road. 5% 4% 3% 2% 1% 0% 1% 2%

Explanation / Answer

a) 4%. Since each point on the demand curve increases by 1600$, therefore the First point of demand curve becomes $2800. hence, equilibrium will be at 4%

b) If supply decreases, then the supply curve shifts to the left by $1600. hence, this means new equilibrium is at 4%

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