Suppose the long-run investment demand and private saving supply curves in the market for loanable funds are given by the following equations:
I = 2000 - 100r S = 500 + 100r
where r represents the real interest rate in percentage points (eg. 10% is represented by 10), and quantities are in billions of dollars. Assume a closed economy and that initially the government is running a balanced budget (ie. government saving initially equals 0).
(a) What is the equation for national saving? Calculate the equilibrium interest rate, aggregate level of investment in the economy, and the aggregate level of national saving. Illustrate in a diagram.
(b) Now suppose that firms revise downward their expectations of the future cash flows from investment projects. Explain why this would lead to a reduction in the demand for loanable funds.
(c) Suppose the event described above results in demand being decreased by 200 at any interest rate. What is the new demand equation? Calculate the new equilibrium. Illustrate in your diagram.
(d) Return to the original supply and demand conditions. Suppose that the government changes its policy so that in the long-run it will run deficits of 500. How does this affect the level of national saving? Calculate the new equilibrium. What is private saving in the new equilibrium?
(e) Explain why the deficit described above might affect future economic growth in GDP, labour productivity, and GDP/capita.