Section 5 - Expanded Loanable Funds Model and Fiscal Policy (10 points) The one panel loanable funds model makes it easy to show how increased government deficits can crowd out private investment. How can we demonstrate crowding out, using our 3 panel loanable funds model? In our three-panel model, households' lending intentions are captured in the three supply curves, provided in the graphs below. Initially the government has a deficit of $500 billion, financed 40% in the t-bond market and 60% in the t-bill market. Assume the Federal Reserve targets a 1% real fed funds rate before the change in fiscal policy, and keeps the same target, after the fiscal policy change. Assume the risky/risk free long rate spread, both before and after the change in fiscal policy, is 2.5%. 1. Label the two government quadrants below and draw in the curves necessary to find equilibrium. Also label the equilibrium value in the corporate panel, and draw the curve using the following information: Corporations demand for funds is a linear function and equals $100 billion if the real rates are 7% and $700 billion if the rates are 4%. (1 point) Now suppose the government deficit rises by $400 billion, financed 50% in t-bonds and 50% in t-bills. OH NW AUM VOO OHNWA VID VOO 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 2. Draw the shifts in the 2 curves, directly caused by the fiscal policy change. (2 points) 3. Draw the shifts in Fed policy that is required to reach its target. (1 point)