Loanable Funds – Principles of Macroeconomics Homework

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Loanable Funds, Government Spending, Savings, Economy, Principles of Macroeconomics

The key words in this Macroeconomics course include Government Spending, Recession, Economy, Savings, Investment, Initial Equilibrium, Loanable Funds, Fiscal Stimulus , Fiscal Policy, Crowding-Out, Million, Aggregate Demand, Supply, Increase, Private Spending – Principles of Macroeconomics.


Suppose a small country is in recession and the government decides to increase spending to boost the economy, and decides to borrow $50 million to build statues of famous economists. Given this knowledge, and based on the graph above, which of the following statements is true

Investment spending will increase beyond $530 million

Investment spending will decrease to $480 billion

Consumption will increase by $30 million

There is a net change in aggregate demand of +30 million

Explanation : Originally, the market is in equilibrium at point A, with an interest rate of 3% and savings and investment being equal at $500 million. Then the demand for loans increases by $50 million at all points when the government borrows $50 million. This change moves the market to a new equilibrium at point B. Government spending (G) will increase by $50 million. Total savings will increase from $500 million to $530 million, which means that total savings will increase by $30 million and consumption (C) will fall by $30 million. But because the government is borrowing $50 million of the savings, private investment (I) will fall to $480 million, a decrease of $20 million. All of this means a net change of zero in aggregate demand
(AD).


Suppose that the president has decided to increase government spending by building more libraries. The legislation was rushed through Congress and enacted without any delay. From here, the libraries will take 10 months to plan and 2 years to build. 

Which of the following is true?

This policy shows an example of automatic stabilizers taking effect.

The planning and building of the libraries represents an impact lag of this policy.

This policy is contractionary.

The planning and building of the libraries represents a recognition lag of this policy.

Explanation : An impact lag would be present.  An impact lag is the time it takes after a policy is enacted for its effects to be completely felt in the economy. In this case, the policy is all about government spending, but because it takes a long time to build the libraries, it’s a while before all the money is completely paid to the construction workers and others doing the work.


The graph below shows initial equilibrium in the loanable funds market at $800 million and an interest rate of 4%, point A. Now, assume that the government increases spending by $100 million that is entirely deficit-financed. The new equilibrium in the loanable funds market is now $840 million and an interest rate of 5%, point B.

If we assume there was no government debt prior to the fiscal stimulus, determine the new quantities for the blanks below.
Savings: _______ million
Investment: _______ million
Private consumption decreases by: _______ million

$740; $740; $60

$840; $840; $40

$840; $740; $40

$840; $840; $60

Explanation : When the demand for loanable funds shifts to the right, total savings increases by $40 million, for a new level of savings of $840 million. Government spending increases by $100 million as stated in the question. This means that private investment has $740 million of savings available ($840 million – $100 million). Finally, private consumption falls by $40 million as anything not consumed is considered savings. Recall that total savings increased by $40 million.


The new classical critique of activist fiscal policy is theoretically different from the crowding-out critique. Crowding-out occurs when private spending __________ in response to government spending. Under the new classical critique, increased government spending leads people to __________ their current savings in order to help pay for higher taxes in the future, which increases the __________ of loanable funds.

decreases; increase; supply

increases; increase; demand

decreases; decrease; supply

decreases; decrease; demand

Explanation : Crowding-out occurs when increased government spending causes a decrease in private spending. The new classical critique explains how saving shifting occurs. As government spending increases, people know they will have to pay higher taxes eventually, which increases current savings. An increase in savings results in the increase in the supply of loanable funds.