- We know from the loanable funds market that as the
interest rate rises, households want to save more and con-
sume less. But at the same time, an increase in the interest
rate lowers the number of investment spending projects
with returns at least as high as the interest rate. The state-
ment “households will want to save more money than
businesses will want to invest” cannot represent an equilib-
rium in the loanable funds market because it says that the
quantity of loanable funds offered exceeds the quantity of
loanable funds demanded. If that were to occur, the inter-
est rate would fall to make the quantity of loanable funds
offered equal to the quantity of loanable funds demanded. - a.The real interest rate will not change. According to the
Fisher effect, an increase in expected inflation drives up
the nominal interest rate, leaving the real interest rate
unchanged.
b.The nominal interest rate will rise by 3%. Each additional
percentage point of expected inflation drives up the nom-
inal interest rate by 1 percentage point.
c.As long as inflation is expected, it does not affect the
equilibrium quantity of loanable funds. Both the supply
and demand curves for loanable funds are pushed
upward, leaving the equilibrium quantity of loanable
funds unchanged.
Tackle the Test:
Multiple-Choice Questions
- c
- b
- b
- c
- a
Tackle the Test:
Free-Response Questions
- a.This causes an increase (rightward shift) in the supply of
loanable funds.
b.This causes a decrease (leftward shift) in the demand for
loanable funds.
c.This causes an increase (rightward shift) in the demand
for loanable funds.
d.This causes a decrease (leftward shift) in the supply of
loanable funds.
Q 2 Q 1 Quantity of
loanable funds
r 2
r 1
Interest
rate, r
S 2
S 1
E 2
E 1
D
Module 30
Check Your Understanding
- The actual budget balance takes into account the effects
of the business cycle on the budget deficit. During reces-
sionary gaps, it incorporates the effect of lower tax rev-
enues and higher transfers on the budget balance; during
inflationary gaps, it incorporates the effect of higher tax
revenues and reduced transfers. In contrast the cyclically
adjusted budget balance factors out the effects of the
business cycle and assumes that real GDP is at potential
output. Since, in the long run, real GDP tends to poten-
tial output, the cyclically adjusted budget balance is a bet-
ter measure of the long-run sustainability of government
policies. - In recessions, real GDP falls. This implies that consumers’
incomes, consumer spending, and producers’ profits also
fall. So in recessions, states’ tax revenue (which depends
in large part on consumers’ income, consumer spending,
and producers’ profits) falls. In order to balance the state
budget, states have to cut spending or raise taxes, but that
deepens the recession. States without a balanced-budget
requirement don’t have to take steps that would make
things worse during a recession, and they can use expan-
sionary fiscal policy to lessen the fall in real GDP. - a.A higher growth rate of real GDP implies that tax rev-
enue will increase. If government spending remains con-
stant and the government runs a budget surplus, the size
of the public debt will be less than it would otherwise
have been.
b.If retirees live longer, the average age of the population
increases. As a result, the implicit liabilities of the gov-
ernment increase because spending on programs for
older Americans, such as Social Security and Medicare,
will rise.
c.A decrease in tax revenue without offsetting reductions in
government spending will cause the public debt to
increase.
d.Public debt will increase as a result of government bor-
rowing to pay interest on its current public debt. - In order to stimulate the economy in the short run, the
government can use fiscal policy to increase real GDP.
This entails borrowing, increasing the size of public debt
further and leading to undesirable consequences: in
extreme cases, governments can be forced to default on
their debts. Even in less extreme cases, a large public debt
is undesirable because government borrowing “crowds
out” borrowing for private investment spending. This
reduces the amount of investment spending, reducing the
long-run growth of the economy.
Tackle the Test:
Multiple-Choice Questions
- b
- d
- c
- d
- e
SOLUTIONS TO AP REVIEW QUESTIONS S-17