Chapter 5R, Problem 1FRQ

a)

To determine

The question requires us to draw a graph representing the loanable fund market and correctly label the variables.

Explanation of Solution

The loanable fund market represents the market supply and demand for loanable funds in an economy. In this market, the individuals’ savings are considered the supply of loanable funds while the loans taken from firms are considered the demand.

An increase in savings in a market indicates a higher supply of loanable funds. Similarly, an increase in demand for loans indicates a higher demand in the loanable fund market.

The following graph represents the market for loanable funds:

  

Here, curve S1 represents the supply curve, and curve D1 represents the demand curve in the loanable fund market. The intersection of the supply and demand curve will give the equilibrium at point E1.

The equilibrium rate of interest is r1.

Q1 is the equilibrium quantity of loanable funds.

b)

To determine

The question requires us to show the impact of increased government spending on the loanable fund market using the graph.

Explanation of Solution

An increase in government spending will increase the level of savings in the economy because people will have more disposable income in their hands to spend or save. When people save more, the supply of loanable funds in the market will increase and as the result, the supply curve will shift to the right from S1 to S2 as shown in the figure.

  

A higher supply of loanable funds causes the equilibrium to reach point E2 where the new interest rate is r2 which is below the initial rate, and Q2 is the new equilibrium quantity of loanable funds.

c)

To determine

The question requires us to determine the impact of the new interest rate on the real GDP level

Explanation of Solution

There is an inverse relationship between the interest rate and the rate of investment.

A higher interest rate reflects higher borrowing costs that disincentivize investors to take loans and make investments in the market or their businesses. Thus, investment in the market will fall.

Similarly, a lower interest rate indicates lower borrowing costs that incentivize the investors to borrow from the loanable fund market, and the investments in the market will increase.

So, a fall in the interest rate from r1 to r2 will increase the investment in the market.

A higher investment causes the real GDP to rise because an increase in investment represents a higher production capacity in the firms that, in turn, causes the production of goods and services to increase and results in a higher real GDP level.