The graph below depicts the market for loanable funds when the government is running a balanced budget. That is, the government is not borrowing or lending funds initially. You will, however, use this diagram to examine the effects of a government budget deficit on the real interest rate and investment spending.

To stimulate economic activity during the current recession, the government has increased government purchases, without raising tax collections. This has created a government budget deficit. The government budget deficit requires the government to borrow $9 billion from the market for loanable funds depicted above. This increases the demand for loanable funds by $9 billion.

Describe the effects of the government budget deficit on 1) the real interest rate, 2) the new equilibrium quantity of loans in the market, 3) the new amount of private borrowing in the economy, and 4) private investment. Also, identify the well-known process or effect that this question and your answer describe.

Each box isNOT$1 billion.

Real Interest Rate 796 Supply 696 III 59% 49% 39% 796 19% Demand $3 $6 $9 $12 $15 $18 $21 Quantity of Loanable Funds (in billions of dollars)