3. Using the loanable funds theory and using a graph representing the market for
ID: 2506413 • Letter: 3
Question
3. Using the loanable funds theory and using a graph representing the market for loanable funds, show and explain how each of the following events affect the equilibrium real interest rate. (Provide an answer for each question separately)
a. A war leads the government to increase spending on the military. (Assume taxes do not change.)
b. Wars in other countries lead to higher government spending in those countries.
c. Someone invents a new kind of computer that makes firms more productive. Many firms want to buy the computer. Higher productivity also increases people
Explanation / Answer
a. A war leads the government to increase spending on the military.
(Assume taxes do not change).
ANSWER: With constant tax revenue and increased government spending, public saving
decreases. This decrease is represented by a leftward shift in the supply of loanable funds and
causes the real interest rate to rise. As the real interest rate rises, the quantity of loans demanded
decreases (this is represented by a movement along the original demand curve).
b. War in other countries lead to higher government spending in those countries.
ANSWER: As the real interest rate is pushed up in other countries (see answer to part [a]),
domestic savers have an incentive to lend their funds abroad. This will cause capital outflows.
An increase in capital outflows reduces the supply of loanable funds domestically and drives up
the domestic real interest rate. This example illustrates that real interest rates in all countries
should move in the same direction as long as capital is allowed to move across national borders.
c. Someone invents a new kind of computer that makes firms more productive. Many firms want to buy the computer. Higher productivity also increases people
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