Loanable Funds Model with Interest Elastic Savings

Group Memo Assignment 2: Loanable Funds Model with Interest Elastic Savings

Assignment Overview – Write a 400 word memo to Congress explaining that their proposal to increase government spending financed by borrowing can have a significant impact on private investment.

Assignment Objective – Using the Loanable Funds Model, you will evaluate the effects of government borrowing under two scenarios. The first scenario assumes that private savings does not depend on the interest rate. In this scenario, the Savings function in the Loanable Funds Model is vertical. The second scenario assumes that private savings does depend on the interest rate, <link is hidden> consumers will save a larger portion of their disposable income as interest rates rise. Under scenario 2, the Savings function in the Loanable Funds Model is upward sloping.

Requirements:

1. Using the loanable funds model and assuming that consumption, and hence private savings, do not depend on the interest rate, demonstrate the impact of an increase in government spending on interest rates and investment. Your response to this requirement must contain a diagram of the Loanable Funds Model.

2. Using the graph you developed in requirement 1 above, explain your results for investment, the interest rate, national saving, and private saving. Your explanation for this requirement is limited to 100 words or less.

3. Assume now that that consumption falls when the interest rate rises, and hence private savings (disposable income minus consumption) rises when the interest rate rises, repeat the analysis at part 1 and 2 above. Your response to this requirement must contain a graph of the Loanable Funds Model. (Please do not use the graph created in requirement 1 above as the savings function is different.)

4. Compare results and explain the differences on the impact of an increase in government spending for investment and interest rate, national saving and private saving under the two alternative assumptions made in requirements 1 and 3. Your explanation for this requirement is limited to 100 words or less. Hint: put the diagrams you developed in requirements 1 and 3 on top of each other, list the differences, and write up an explanation with a short sentence for each variable.