Question

Suppose the economy is closed and consumption of $10,000, taxes are $2000 and government purchases are $3,000 and national saving is $1,500. In the era of covid-19 pandemic, the producers were pessimistic about the returns of capital and reduced their investments. Use a well-labelled diagram of loanable funds market to illustrate and explain the impacts on the equilibrium interest rate and quantity of loanable funds.

Answer 1

A decrease in private investment due to pessimism by producers about the returns of capital will increase the equilibrium interest rate and decrease the equilibrium quantity of loanable funds in the loanable funds market.

Step-by-step explanation:

In the loanable funds market, a decrease in private investment due to pessimism by producers about the returns of capital will result in a decrease in the quantity of loanable funds supplied. This will cause a leftward shift of the supply curve of loanable funds. As a result, the equilibrium interest rate will increase, and the equilibrium quantity of loanable funds will decrease.

This can be illustrated in a well-labelled diagram of the loanable funds market. The original equilibrium (E) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, with the decrease in private investment, the supply curve shifts leftward, leading to a new equilibrium (E₁) at a higher interest rate of 6% and a lower equilibrium quantity of loanable funds.