8. Suppose the government borrow $20 billion more next year than this year.Use a supply-and demand diagram to analyze this policy . Does the interest rate rise or fall ?What happens to investment ? To private saving ? To public saving ? To national saving ? Compare the size of the changes to the $20 billion of extra government borrowing. How does the elasticity of supply of loanable funds affect the size of these changes ? How does the elasticity of demand for loanable funds affect the size of these changes? Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future . what does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in part (a) and (b)?

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Asked Oct 7, 2019
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8. Suppose the government borrow $20 billion more next year than this year.

  1. Use a supply-and demand diagram to analyze this policy . Does the interest rate rise or fall ?
  2. What happens to investment ? To private saving ? To public saving ? To national saving ? Compare the size of the changes to the $20 billion of extra government borrowing.
  3.  How does the elasticity of supply of loanable funds affect the size of these changes ?
  4.  How does the elasticity of demand for loanable funds affect the size of these changes?
  5.  Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future . what does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in part (a) and (b)?

 

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Expert Answer

Step 1

If the government borrow $20 billion more next year than this year it means government is running a budget deficit that is, they are spending more money than their income.

If government borrow from the market, it pulls out the money from the market that reduces the supply available. This reduction in supply of funds, shift the supply curve to the left and increases the interest rate.

Since interest rate is high than previous one, it reduces the borrowing from the money market.

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Rate of interest S2 S1 i Quantity of loanable funds

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Step 2

In the figure, due to leftward shift in supply curve quantity of loanable funds reduces from q to q’ and rate of interest increases from i to i’.

There is negative relationship between investment and interest rate. The higher the interest rate, lower the investment and lower the interest rate, higher the investment. For example, it is easy to invest in a new project when individual easily gets the loan from the banks but if interest rate is high, investors avoid borrowing because it’s increases their cost.

Step 3

Private saving:

Y = C+S+T

S = Y – T – C

Where Y is the national income, T is the tax, C is the consumption, and S is the saving. Saving is the amount left over of income after consumption and tax payments. Since government expe...

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