5. The market for loanable funds and government policyThe following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help youcomplete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of eachindividual scenario. (Note: You will not be graded on any changes you make to the graph.)INTEREST RATE (Percent)IDemandLOANABLE FUNDS (Billions of dollars)SupplyDemandSupply* Scenario 1: Individual Retirement Accounts (IRAS) allow people to shelter some of their income from taxation. Suppose the maximum annualcontribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.Shift the appropriate curve on the graph to reflect this change.This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds tospending toScenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose thegovernment repeals a previously existing investment tax credit.Shift the appropriate curve on the graph to reflect this change.The repeal of the previously existing tax credit causes the interest rate toThis change in spending causes the government to run a budgetScenario 3: Initially, the government's budget is balanced; then the government responds to the conclusion of a war by significantly reducing defensespending without changing taxes.Shift the appropriate curve on the graph to reflect this change.and the level of saving toThis causes the interest rate towhichand the level of investmentthe level of investment spending.national saving.

Answered: 5. The market for loanable funds and…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

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5. The market for loanable funds and government policy
The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you
complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each
individual scenario. (Note: You will not be graded on any changes you make to the graph.)
INTEREST RATE (Percent)
I
Demand
LOANABLE FUNDS (Billions of dollars)
Supply
Demand
Supply
*

Scenario 1: Individual Retirement Accounts (IRAS) allow people to shelter some of their income from taxation. Suppose the maximum annual
contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.
Shift the appropriate curve on the graph to reflect this change.
This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to
spending to
Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the
government repeals a previously existing investment tax credit.
Shift the appropriate curve on the graph to reflect this change.
The repeal of the previously existing tax credit causes the interest rate to
This change in spending causes the government to run a budget
Scenario 3: Initially, the government's budget is balanced; then the government responds to the conclusion of a war by significantly reducing defense
spending without changing taxes.
Shift the appropriate curve on the graph to reflect this change.
and the level of saving to
This causes the interest rate to
which
and the level of investment
the level of investment spending.
national saving.

Expert Solution

Scenario _1

If the maximum annual contribution to the individual retirement accounts, it will incentivize people to put more money in their retirement account. We are assuming that people who are managing this funds use this fund to make investments and give loans. Hence the supply of the loanable funds would increase. With the given level of demand, this would lead to excess supply of loanable funds => lower the interest rate .

As we can see in the below diagram, this will lead to shift the supply curve to the right and hence at the new equilibrium we have higher quantity of loanable funds and the lower interest rate.

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