Final answer:
Changes in the interest rate would not shift a perfectly vertical IS curve to reach a new equilibrium. Instead, fiscal policy would be needed for adjustment. Government borrowing affecting the demand for financial capital can lead to higher interest rates and a change in the equilibrium quantity of financial capital.
Step-by-step explanation:
The question relates to a hypothetical situation where the IS curve (Investment-Savings) is perfectly vertical, meaning that the level of investment does not change with fluctuations in interest rates. In this case, the IS curve is described by the equation Y=5. In reality, if an IS curve is perfectly vertical, changes in the interest rate would not affect the level of output (Y), and hence, the curve would not shift to reach a new equilibrium through changes in the interest rate alone. Instead, fiscal policy (changes in government spending and/or taxes) would be required to move the economy to a new equilibrium.
When discussing the effect of government borrowing on financial markets, we must consider the supply and demand for financial capital. If a government borrows more, causing the demand curve for financial capital to shift, this can result in higher interest rates. For example, in the scenario provided, an increase in the government budget deficit would shift the demand curve from D0 to D1, leading to a new equilibrium with a higher interest rate of 6% and a higher quantity of financial capital at 21% of GDP.
The elasticity of savings in financial markets, being the ratio of the percentage change in the quantity of savings to the percentage change in interest rates, shapes the supply curve for financial capital. A vertical IS curve implies zero elasticity of investment with respect to interest rates, so changes in the interest rate would not alter investment levels. In the case of a perfectly inelastic investment function (as illustrated by a flat line), it would not shift with changes in national income, but other factors such as technological opportunities, economic growth expectations, or changes in interest rates might shift it up or down, affecting the overall level of investment in the economy.