Loanable Funds Model with Interest Elastic Savings

Practice - Write a memo to Congress explaining that their proposal to increase government spending financed by borrowing can have a significant impact on private investment.

Objective - Using the Loanable Funds Model, you will evaluate the effects of government borrowing under two scenarios. The first scenario assumes that private savings does not depend on the interest rate. In this scenario, the Savings function in the Loanable Funds Model is vertical. The second scenario assumes that private savings does depend on the interest rate, i.e. consumers will save a larger portion of their disposable income as interest rates rise. Under scenario 2, the Savings function in the Loanable Funds Model is upward sloping.

Instructions

1.Using the loanable funds model and assuming that consumption, and hence private savings, do not depend on the interest rate, demonstrate the impact of an increase in government spending on interest rates and investment. Your response to this requirement must contain a diagram of the Loanable Funds Model.

2.Using the graph you developed in requirement 1 above, explain your results for investment, the interest rate, national saving, and private saving. Explain in less than 100 words.

3.Assume now that that consumption, and hence private savings, depends on the interest rate negatively; repeat the analysis at part 1 and 2 above. Your response to this requirement must contain a graph of the Loanable Funds Model.

4.Compare results and explain the differences on the impact of an increase in government spending for investment and interest rate, national saving and private saving under the two alternative assumptions made in requirements 1 and 3.Explain in less than 100 words. Hint: put the diagrams you developed in requirements 1 and 3 on top of each other, list the differences, and write up an explanation with a short sentence for each variable.