A budget deficit occurs when the governments spending exceeds tax revenue.
By decreasing the supply of loanable funds, a budget deficit leads to a leftward shift in the supply curve for loanable funds, leading to an increase in the equilibrium interest rate.
This increase in the interest rate results in a decrease in the quantity of investment. This is referred to ‘crowding out.’
#2 What would be the result if instead of a budget deficit, the government had a budget surplus? Use a graph.
As shown in the graph below, the economy starts in equilibrium at point E0 with interest rate r0 and equilibrium quantity of saving and investment at q0. If the government succeeds in obtaining a surplus, there will be more public saving in the economy and so more national saving at each interest rate, and the supply of loanable funds curve will shift from S0 to S1. The new equilibrium will be at E1, with a lower interest rate, r1 and a higher quantity of saving and investment, q1. Hence, if the federal government succeeds in having a surplus, interest rates will fall and investment will increase.
#3 What happens if there is an increase in the demand for loanable funds?
An increase in the demand for loanable funds shifts the demand curve for loanable funds to the right, leading to an increase in the equilibrium interest rate.
