In \(2014,\) Congress estimated that the cost of increasing support and expanding pre-kindergarten education and infant and toddler childcare would cost \(\$ 28\) billion. Since the U.S. government was running a budget deficit at the time, assume that the new pre-K funding was financed by government borrowing, which increases the demand for loanable funds without affecting supply. This question considers the likely effect of this government expenditure on the interest rate. a. Draw typical demand \(\left(D_{1}\right)\) and supply \(\left(S_{1}\right)\) curves for loanable funds without the cost of the expanded pre-K programs accounted for. Label the vertical axis "Interest rate" and the horizontal axis "Quantity of loanable funds." Label the equilibrium point \(\left(E_{1}\right)\) and the equilibrium interest rate \(\left(r_{1}\right)\). b. Now draw a new diagram with the cost of the expanded pre-K programs included in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point \(\left(E_{2}\right)\) and the new equilibrium interest rate \(\left(r_{2}\right)\) c. How does the equilibrium interest rate change in response to government expenditure on the expanded pre-K programs? Explain.

Step by step solution

01

Draw the initial demand (D1) and supply (S1) curves for loanable funds.

Start by drawing a graph with the vertical axis labeled "Interest rate" and the horizontal axis labeled "Quantity of loanable funds." Draw a downward sloping line representing the initial demand for loanable funds (D1) and an upward sloping line representing the initial supply of loanable funds (S1). Label the point where these two lines intersect as E1, representing the equilibrium point in the market. Mark the interest rate at this point as r1, the initial equilibrium interest rate.

02

Include the cost of expanded pre-K programs in the analysis.

Now, we will consider the effect of government borrowing to support expanded pre-K programs. Since the government is borrowing, this would increase the demand for loanable funds without affecting the supply. To represent this, draw a new demand line (D2) to the right of the initial demand line (D1), indicating that the cost of the expanded pre-K programs has increased the demand for loanable funds.

03

Draw a new diagram with the new demand curve (D2).

After drawing the new demand curve (D2), we need to find its intersection with the initial supply curve (S1) to determine the new equilibrium point (E2) and the new equilibrium interest rate (r2). Label the intersection of these two lines as E2 and the interest rate at this point as r2.

04

Analyze the changes in the equilibrium interest rate.

To answer the question regarding how the equilibrium interest rate changes in response to government expenditure on expanded pre-K programs, compare the initial equilibrium interest rate (r1) with the new equilibrium interest rate (r2). Since the demand for loanable funds has increased without a change in the supply, the interest rate would also increase as lenders require a higher rate to compensate for the increased demand. Therefore, the equilibrium interest rate (r2) will be higher than the initial equilibrium interest rate (r1). In conclusion, government expenditure on expanded pre-K programs, financed through borrowing, will lead to an increase in the demand for loanable funds without affecting the supply. This results in a higher equilibrium interest rate, as lenders require a higher rate to meet the increased demand.

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