Question: Using the model of loanable funds developed in Chapter 3, explain how the following changes affect the real interest rate, investment, consumption, and government expenditure.

Using the model of loanable funds developed in Chapter 3, explain how the following changes affect the real interest rate, investment, consumption, and government expenditure. Include the appropriate diagram as part of your answer in each case. Initially assume that consumption depends only on disposable income.

(a) The government decreases taxes.

(b) Expectations about the future profitability of investment worsen. (Hint: For a given real interest rate, r, firms will invest a lesser amount after expectations worsen).

(c) How does your answer to (b) change if consumption also depends on the real interest rate (i.e. is decreasing with r)?

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