1.8. In 2006, Congress estimated that the cost of the Iraq War was approximately $100 billion a year. Since the U.S. government was running a budget deficit at the time, assume that the war was financed by government borrowing, which increases the demand for loanable funds without affecting supply. This question considers the likely effect of this government expenditure on the interest rate.

a. Draw typical demand (D1) and supply (S1) curves for loanable funds without the cost of the war accounted for.

Label the vertical axis “Interest rate” and the horizontal axis “Quantity of loanable funds.” Label the equilibrium point (E1) and the equilibrium interest rate (r1).

b. Now consider a new diagram with the cost of the war included in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point (E2)

and the new equilibrium interest rate (r2).

c. How does the equilibrium interest rate change in response to government expenditure on the war? Explain.