Question

Part 1: Graphing the Loanable Funds Market Assignment

Show the changes for each scenario on a properly drawn and labeled loanable funds market graph. Then describe what happened to real interest rates and the quantity of loanable funds. Each question is worth two points, one point for your graph and one for your description of what happened.

1. The government is preparing to run a deficit in order to pay for a war.

2. Due to worries about the future, Americans significantly increase their savings.

3. A prolonged recession has prompted the government to cut taxes and increase spending.

4. America is experiencing a high rate of inflation. To fight it, the government has increased taxes and cut spending.

5. Explain what crowding out is. In which scenarios could crowding out most likely occur? Explain.


Part 2: AP Free Response Question

1. Assume that the economy of Country Z is operating on the upward-sloping portion of its short-run aggregate supply curve. Assume that the government increases spending. This question will be graded out of 6 points.

(a) How will the increase in government expenditures affect each of the following in the short run?

(i) Aggregate demand

(ii) Short-run aggregate supply

(b) Using a correctly labeled graph of aggregate demand and aggregate supply, show the effect of the increase in government expenditures on real output and the price level.

(c) Assume that the government funded this increase in expenditure by borrowing from the public. Using a correctly labeled graph of the loanable-funds market, show the effect of the increase in government borrowing on the real interest rate.

Answer 1

(a) (i) The increase in government expenditures will lead to an increase in aggregate demand, as the government is injecting money into the economy. (ii) The short-run aggregate supply will be unaffected by the increase in government expenditures, as it is an inelastic curve.

(b) The increase in aggregate demand will cause the price level to rise and the quantity of real output to increase.

(c) The increase in government borrowing will lead to an increase in the demand for loanable funds. This will cause the real interest rate to rise, as the supply of loanable funds is inelastic.

Step-by-step explanation: