Exercises: The Loanable Funds Market and Crowding Out

In the loanable funds market, who supplies funds and who demands them? State what is measured on each axis of the graph.

The federal government runs a larger budget deficit and borrows more by selling bonds. Which curve in the loanable funds market shifts, and in which direction? What happens to the equilibrium real interest rate?

Define crowding out. Explain in two sentences how government borrowing can lead to it.

Before a larger government deficit, the loanable funds market has an equilibrium real interest rate of 4% and a quantity of $\$800$ billion, all of it private investment. After the government borrows an extra $\$100$ billion, the equilibrium real rate is 5% and the equilibrium quantity of loanable funds is $\$850$ billion. Compute private investment after the deficit increase and the amount of crowding out. Explain the mechanism.

For each event, state which curve in the loanable funds market shifts, in which direction, and what happens to the equilibrium real interest rate and quantity. (a) Households decide to save more. (b) Firms expect higher future profits and want to build new factories. (c) The federal government moves from a deficit to a surplus. (d) Foreign savers increase their lending to the US.

The government increases spending by $\$100$ billion, and the MPC is 0.8. (a) Compute the change in real GDP using the simple multiplier. (b) The resulting borrowing raises the real interest rate and reduces private investment by $\$40$ billion. Compute the reduction in real GDP due to crowding out, using the same multiplier, and the net change in real GDP. (c) Explain why crowding out weakens the effectiveness of fiscal stimulus.

Compare two uses of a $\$300$ billion government deficit: a debt-financed tax cut that mainly raises consumption, and spending on infrastructure that raises future productivity. (a) Explain the effect of each on the loanable funds market. (b) Explain why crowding out is likely to be larger when the economy is at full employment than when it is in a deep recession. (c) Evaluate the long-run effect of each policy on economic growth, and say which one you would favor and why.

In an economy, private demand for loanable funds is $Q_d = 1{,}000 - 100r$ and supply of loanable funds is $Q_s = 200 + 100r$, where $Q$ is in billions of dollars and $r$ is the real interest rate in percent. (a) Find the equilibrium real interest rate and quantity. (b) The government now borrows an extra $\$100$ billion at every interest rate, so total demand becomes $Q_d = 1{,}100 - 100r$. Find the new equilibrium real interest rate and quantity. (c) Compute private investment at the new interest rate and the amount of crowding out. (d) Explain why crowding out is only partial, not complete, in this model.