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Chapter 21: Problem 17

The federal government in the United States has been running large budget deficits. Suppose that Congress and the president take actions that turn the budget deficits into budget surpluses. a. Use a market for loanable funds graph to illustrate the effect of the federal budget surpluses. What happens to the equilibrium real interest rate and the quantity of loanable funds? What happens to the level of saving and investment? b. Now suppose that households believe that surpluses will result in Congress and the president cutting taxes in the near future in order to move from budget surpluses to balanced budgets. As a result, households increase their consumption spending in anticipation of paying lower taxes. Briefly explain how your analysis in part (a) will be affected.

Short Answer

Expert verified
With a budget surplus, the supply of loanable funds increases, leading to a fall in the real interest rate and increase in investment. But, if households anticipate a future tax cut and increase their current spending, this reduces the supply of loanable funds, leading to an increase in the equilibrium interest rate and a decrease in investment compared to the scenario after the budget surplus before the anticipated tax cut.

Step by step solution

01

Understanding the Market for Loanable Funds

The market for loanable funds is a conceptual marketplace where borrowers and lenders interact. This market determines the real interest rate, which balances the amount of funds people want to save, the source of loanable funds, with the amount of funds people want to borrow, or invest. In this market, the supply of loanable funds comes from savings and the demand for loanable funds comes from investment.
02

Illustrating the Impact of Surplus on the Market for Loanable Funds

When the government turns a budget deficit into a surplus, it means it is spending less than it's collecting in taxes. This means it's withdrawing less from the nation's pool of savings or in other words it is adding to the national savings. This increase in national savings will shift the supply curve for loanable funds to the right. As a result, the equilibrium interest rate will fall and the quantity of loanable funds (investment) will increase. The lower real interest rate increases the incentives for firms to borrow and invest, thus increasing the quantity of loanable funds demanded.
03

Analyzing the Effect of Anticipated Tax Cut

Now if households believe that this budget surplus will lead to a future tax cut, they may decide to increase their current consumption in anticipation of paying lower taxes in the future. This reduces current saving, shifting the supply of loanable funds leftward. This decrease in supply will offset the initial increase in supply from the budget surplus. Depending on the extent of the decrease in savings, the final impact on the real interest rate and investment could vary. However, the general effect would be a decrease in the quantity of loanable funds and increase in the equilibrium real interest rate, compared to the scenario after the budget surplus before the anticipated tax cut.

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