Question

5. The market for loanable funds and government policy The following graph shows the loanable funds market. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Consider each scenario separately by returning the graph to its starting position when moving from one scenario to the next. (Note: You will not be graded on any changes you make to the graph.) Demand Supply INTEREST RATE (Percent) LOANABLE FUNDS (Billions of dollars) Demand Supply Scenario 1: Suppose savers either buy bonds or make deposits in savings accounts at banks. Initially, the interest income earned on bonds or deposits is taxed at a rate of 18%. Now suppose there is a decrease in the tax rate on interest income, from 18% to 14%. Shift the appropriate curve on the graph to reflect this change. This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to and the level of investment spending to .

Answer 1

Explanation:

In Scenario 1, the change in the tax treatment of saving from 18% to 14% will affect the equilibrium interest rate in the market for loanable funds and the level of investment spending.

To understand the impact, we need to consider the relationship between the tax rate on interest income and saving. A decrease in the tax rate on interest income means that savers will have a higher after-tax return on their investments. This change will incentivize savers to save more and invest in bonds or savings accounts.

1. Effect on the supply of loanable funds:

With the decrease in the tax rate, savers will have more incentive to save and supply loanable funds. As a result, the supply curve for loanable funds will shift to the right, indicating an increase in the supply of funds.

2. Effect on the demand for loanable funds:

The decrease in the tax rate does not directly affect the demand for loanable funds. Therefore, the demand curve for loanable funds remains unchanged.

3. Equilibrium interest rate:

The increase in the supply of loanable funds will put downward pressure on the interest rate. As a result, the equilibrium interest rate in the market for loanable funds will decrease.

4. Level of investment spending:

The decrease in the interest rate will make borrowing cheaper for businesses and individuals. This lower interest rate will incentivize more investment spending, as it becomes more attractive to borrow funds for investment projects. Therefore, the level of investment spending will increase.

In summary, the decrease in the tax rate on interest income will shift the supply curve for loanable funds to the right, leading to a decrease in the equilibrium interest rate and an increase in the level of investment spending.

Answer 2

A decrease in the tax rate on interest income from 18% to 14% would likely shift the demand curve for loanable funds to the right, increasing the equilibrium interest rate and the level of investment spending.

In the loanable funds market, the equilibrium interest rate and quantity of loanable funds are determined by the intersection of the demand and supply curves.

The demand for loanable funds comes from investors and businesses seeking capital for investment, while the supply is provided by savers who are willing to lend money.

Scenario 1 involves a change in the tax treatment of interest income earned by savers. Initially, with a tax rate of 18%, the after-tax return on savings is lower, leading to a lower quantity of loanable funds supplied. To reflect the decrease in the tax rate from 18% to 14%, we need to adjust the supply curve.

A decrease in the tax rate on interest income makes saving more attractive as the after-tax return increases. Savers are incentivized to buy more bonds or make deposits, resulting in an upward shift in the supply curve.

This shift signifies an increase in the quantity of loanable funds supplied at each interest rate.

As a consequence of the change, the equilibrium interest rate in the market for loanable funds decreases. The lower tax rate encourages more saving, pushing down interest rates. S