Suppose the 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. Assume that 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) Suppose that firms revise downward their expectations of the future cash flows from investment projects and the result is that demand is decreased by 200 at any interest rate. What is the new demand equation? Calculate the new equilibrium. Illustrate in your diagram.
(c) Return to the original supply and demand conditions. Suppose now that the government changes policy and will run deficits equal to 500 to finance current government services. How does this affect the level of national saving? Calculate the new equilibrium. What is the level of private saving in the new equilibrium?
(d) With reference to an aggregate production function, explain why the deficit described above might affect future economic growth.