Suppose that the loanable fund market is in equilibrium at real interest rate r1. The government then decides to spend more, increasing the budget deficit. The new supply curve (S2) is shown in the graph below:

a. Identify the new equilibrium real interest rate and quantity of loanable funds.
b. How would your answer change if the increase in the budget deficit was accompanied by a significant increase in imports to the United States?
c. During the early 1980s, large government budget deficits were accompanied by large trade deficits. Use your analysis in parts a. and b. to explain why real interest rates did not rise significantly even with a major increase in government borrowing.

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L2 L1 Loanable funds (dollars per year)