Final answer:
An investment tax credit increases the demand for loanable funds by making investment more appealing to firms, which prompts a rightward shift in the demand curve and results in higher interest rates. This can lead to crowding out of private investment and have varying impacts on aggregate demand.
Step-by-step explanation:
The impact of an investment tax credit on the demand for loanable funds is that businesses are more incentivized to invest in capital. These tax credits reduce the effective cost of investment, making it more attractive for firms to borrow money to invest in physical capital.
As a result, the demand for loanable funds shifts to the right from Do to D₁. On a graph representing the financial market, this shift to D₁ results in an equilibrium interest rate increase from 5% to 6%, as depicted from Eo to E₁.
This rise in interest rates is a clear example of how an investment tax credit can stimulate investment demand and potentially crowd out private investment due to more expensive borrowing costs. The increased demand from businesses seeking to take advantage of the tax credit leads to a higher interest rate, making borrowing more costly for other purposes like consumer spending on big-ticket items.
Moreover, with higher interest rates, firms with available funds may find it more lucrative to invest in financial markets rather than in expanding their physical capital, further affecting aggregate demand negatively.