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Use the diagram of the loanable funds market to illustrate the effect of the following events on the equilibrium interest rate and investment spending.
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Loanable Funds Markets Problem Set
b. Retired people generally save less than working people at any interest rate. The proportion of retired people in the population goes up. Savings fall due to the higher proportion of retired people, and the supply of loanable funds decreases. This is illustrated by the leftward shift of the supply curve from S 1 to^ S 2 in the accompanying diagram. The equilibrium moves from E 1 to E 2 , the equilibrium interest rate rises from r 1 to r 2 , and the equilibrium quantity of loanable funds falls from Q 1 to Q 2.
b. At any given interest rate, consumers decide to save more. Assume the budget balance is zero. If consumers decide to save more, there will be an increase in the supply of loanable funds. In the accompanying figure, this is represented by the rightward shift of the supply curve from S 1 to S 2. The increase in the supply of loanable funds reduces the equilibrium interest rate from r 1 to r 2. In response to the lower interest rate, private investment spending will rise from Q 1 to Q 2.
c. At any given interest rate, businesses become very optimistic about the future profitability of investment spending. Assume the budget balance is zero. Higher investment spending at any given interest rate leads to an increase in the demand for loanable funds. In the accompanying figure, the increase in the demand for loanable funds shifts the demand curve from D 1 to D 2 and raises the equilibrium interest rate from r 1 to r 2. In response to the higher interest rate, private savings will rise from Q 1 to Q 2.