This is the question:

Suppose the loanable funds supplied by private households (SP) is i = 2 + 0.01LF where i is interest rate in percentage term and L F is amount of loanable funds. The demand for loanable funds (DLF) is 1' = 7 0.01LF. (a) ('3) Assume the government has a budget surplus of 100. Explain how you can use the information provided to plot the supply of loanable funds (SLF) curve in the graph provided below. Then, plot the demand for loanable funds (DLF) curve in the same graph. Explain how to determine the equilibrium interest rate i'\The Effect of a Government Budget Deficit When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to $2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $120 billion to $80 billion. Interest S2 Rate Supply, S1 6% 1. A budget deficit decreases the 5%-..... supply of loanable funds . . . 2. .. . which raises the equilibrium Demand interest rate . . . $80-$120 Loanable Funds @2018 Cengage Learning (in billions of dollars) 3. . . . and reduces the equilibrium quantity of loanable funds. First, which curve shifts when the government starts running a budget deficit? Recall that national saving-the source of the supply of loanable funds-is composed of private saving and public saving. A change in the government budget balance represents a change in public saving and, thereby, in the supply of loanable funds. Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds.Second, which way does the supply curve shift? When the government runs a budget deficit, public saving is negative, and this reduces national saving. In other words, when the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms. Thus, a budget deficit shifts the supply curve for loanable funds to the left from S1 to S2, as shown in Figure 8.4. Third, we can compare the old and new equilibria. In the figure, when the budget deficit reduces the supply of loanable funds, the interest rate rises from 5 percent to 6 percent. This higher interest rate then alters the behaviour of the households and firms that participate in the loan market. In particular, many demanders of loanable funds are discouraged by the higher interest rate. Fewer families buy new homes, and fewer firms choose to build new factories. The fall in investment because of government borrowing is called crowding out and is represented in the figure by the movement along the demand curve from a quantity of $120 billion in loanable funds to a quantity of $80 billion. That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits follows directly from their effects on the supply and demand for loanable funds: When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls.FIGURE 8.3 An Increase in the Demand for Loanable Funds If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $140 billion. Interest Rate Supply 1. An investment tax credit increases 6% ..... the demand for loanable funds . . . 5% ......................................... 2. . . . which raises the D2 equrllbnum interest rate . . . 0 $12 $140 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 6 2018 C-engage Leaning tax laws encouraged greater investment, the result would be higher interest rates and greater saving. 8-3d Policy 3: Government Budget Deficits and Surpluses Many of the most pressing policy issues that have arisen over the past 30 years in Canada have either directly or indirectly resulted from large government budget deficits and the debt that accumulated as a result of these deficits. When a government spends more than it receives in tax revenue, the shortfall is called the government's budget deficit. When a government spends less than it receives in tax revenue, the excess is called the government's budget surplus. When a government spends exactly what it receives in tax revenue it is said to have a balanced budget. The sum of all past budget deficits minus the sum of all past budget surpluses is called the government debt. From 1975 to 1997 the federal government ran very large budget deficits, resulting in a rapidly growing federal government debt. During the same period, many provincial and territorial governments also ran large deficits, resulting in rapidly growing debts at the provincial/territorial level as well. During the early 2000s, Canadian governments realized sizable budget surpluses. This allowed them to retire some fraction of the debt they accumulated previously. Finally, since 2008, Canadian governments have again returned to deficits and debt accumulation. What has been the effect of all this on the Canadian market for loanable funds? We can use our model to find out. Imagine that the government starts with a balanced budget and then, because of a tax cut or a spending increase, starts running a budget deficit. We can analyze the effects of the budget deficit by following our three steps in the market for loanable funds, as illustrated in Figure 8.4.FIGURE 8.2 An Increase in the Supply of Loanable Funds A change in the tax laws to encourage Canadians to save more would shift the supply of loanable funds to the right from 81 to 5'2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $160 billion. Interest Su I .5 5 Rate DPY 1 2 1. Tax incentives for sawing Increase the SUPP\" f \"mama 4% funds . . . 2. . . . which Demand reduces the equilibrium interest rate . . . 0 $120? $160 Loanable Funds 1" (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 0 2018 C-engage Learring Second, which way would the supply curve shift? Because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. Households would use this additional saving to increase their deposits in banks or to buy more stocks and/or bonds. The supply of loanable funds would increase, and the supply curve would shift to the right from .31 to 32, as shown in Figure 8.2. Finally, we can compare the old and new equilibria. In the gure, the increased supply of loanable funds reduces the interest rate from 5 percent to 4 percent. The lower interest rate raises the quantity of loanable funds demanded from $120 billion to $160 billion. That is, the shift in the supply curve moves the market equilibrium along the demand curve. With a lower cost of borrowing, households and rms are motivated to borrow more to nance greater investment. Thus, if a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment. Although this analysis of the effects of increased saving is widely accepted among economists, less consensus exists about what kinds of tax changes should be enacted. Many economists endorse tax reform aimed at increasing saving in order to stimulate investment and growth. Yet others are skeptical that these tax changes would have much effect on national saving. These skeptics also doubt the equity of the proposed reforms. They argue that, in many cases, the benets of the tax changes would accrue primarily to the wealthy, who are least in need of tax relief. This argument would hold true, for example, with respect to increasing allowable RRSP contributions, because most RRSP contributions are made by those who are relatively wealthy. We examine this debate more fully in the nal chapter of this book