Answered: The following graph shows the loanable…

Exploring Economics

8th Edition

ISBN:9781544336329

Author:Robert L. Sexton

Publisher:Robert L. Sexton

Chapter21: Financial Markets, Saving, And Investment

Section: Chapter Questions

Problem 8P

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Question

The following graph shows the loanable funds market in the United States. It plots both the demand (D) for loanable funds and the supply (S) of loanable funds. At the current equilibrium, the government is operating with a balanced budget. Assume now that the financial industry is close to bankruptcy and the U.S. government decides to implement a bailout plan of several billion dollars without increasing taxes, causing a budget deficit.

Show the effect of the budget deficit on the market for loanable funds by shifting the demand (D) curve, the supply (S) curve, or both.

Based on this model, the budget deficit leads to (an increase/a decrease) in the level of investment and (an increase/a decrease) in the interest rate.

Which of the following arguments might a supporter of a balanced budget make in defense of their position? Check all that apply.

-An individual's share of the government debt represents only a small portion of his or her lifetime earnings.

-A decrease in spending today, such as funding cuts in education, may hurt future generations more.

-Budget deficits decrease national saving.

-Budget deficits place a burden on future taxpayers.

Supporters of a balanced budget claim that the government's budget deficit cannot grow forever, but critics believe that this is not necessarily true. They argue that what matters is the size of debt relative to national income.

For example, suppose that real output in the United States grows at approximately 4%. If the inflation rate is 3% per year, this means that nominal income must be growing at a rate of ____% per year. Because nominal income grows over time, the nation's ability to pay back the national debt also rises. Therefore, as long as the nation's income grows (slower/faster) than the government debt, the level of debt can continue to increase without harming the economy. In this case, the nominal government debt can rise by _____% each year without increasing the debt-to-income ratio.

Show the effect of the budget deficit on the market for loanable funds by shifting the demand (D) curve, the supply (S) curve, or both.
INTEREST RATE
LOANABLE FUNDS
S
D
D
☐
S

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