Question

(e) Assume the government decreased deficit spending at the same time that it lowered the tax rate. Indicate the likely short-run impact on each of the following (increase, decrease, remain constant, or indeterminate):

i. equilibrium real interest rate: decrease

ii. equilibrium quantity of loanable funds

Answer 1

In the short run, decreasing government deficit spending while lowering tax rates likely causes the equilibrium real interest rate to decrease. Yet, the outcome on the equilibrium quantity of loanable funds is less clear and could be indeterminate because it depends on the effects of both policy changes on saving and investment behaviors.

Step-by-step explanation:

When a government decreases deficit spending and simultaneously lowers the tax rate, there are conflicting effects on the loanable funds market. Decreased government borrowing would typically lead to a decrease in the equilibrium real interest rate, as the demand for loanable funds would be reduced. On the other hand, lowering taxes tends to increase disposable income, which can boost savings and shift the supply of loanable funds to the right, putting additional downward pressure on the interest rate. However, the lower taxes can also increase aggregate demand, which might increase investment demand and shift the demand curve for loanable funds to the right, potentially raising the interest rate.

In summary, the short-run impact on the equilibrium real interest rate is indeed likely to decrease due to the reduced government borrowing. However, the impact on the equilibrium quantity of loanable funds is more complex and could be indeterminate without more specific information about the relative magnitudes of the changes in government spending, taxes, and the resulting shifts in demand and supply for loanable funds.