Tutorial 3

1. Use the loanable-funds diagram to illustrate the effects on saving and investment of A policy of limiting demand for funds to industrial projects by prohibiting lending to consumers, government and agriculture A law prohibiting the charging of interest A tax equal to 2% of the value of funds lent

The loanable funds diagram

Saving (supply of loanable funds) As interest rates increase it become more beneficial to lend. Hence a positive slope. Investment (demand for loanable funds) As interest rates increase it becomes less attractive to burrow. Hence a negative slope. A stable equilibrium between supply and demand is established in the same way as for products in microeconomics

Interest rate (equilibrium)

(equilibrium) Quantity of loanable funds

i) A policy of limiting demand for funds to industrial projects by prohibiting lending to consumers, government and agriculture:

Rate of Interest r1 r2

I1 I2

I2

I1

Savings and Investment

Explanation on next slide

 The investment curve is downward sloping as lower interest results in lower return. With this particular example, some investment projects have been ruled out as they have been forbidden and so the investment curve shifts to the left.
This is worrying for savers because their return is lower but good for those who receive government funding. The amount in which the curve shifts to the left depends on the demand for industrial projects.

A law prohibiting the charging of interest

This is effectively the same as setting an interest rate ceiling in the loanable funds market. Much like any other supply and demand diagram if this ceiling is above equilibrium then it will have no effect but if it is below the equilibrium interest rate (the price of loanable funds) it will cause shortages. This is demonstrated in the following diagram:

A law prohibiting the charging of interest

Saving (supply of loanable funds) Interest rate (equilibrium)

=
Interest rate ceiling Investment (demand for loanable funds)

(equilibrium) Quantity of loanable funds

At the interest rate ceiling lenders are less willing to lend and borrowers are more willing to borrow. This results in the shortage seen in the diagram. As investment requires savings (borrowers require lenders) the actual level of investment will drop to the lower level of saving. This will have an adverse effect on the economies output and growth.

There are many factors which effect the level of burrowing besides interest rates. These other factors lead to shifts in the investment curve given the axis we have plotted it against. One of these A 2% tax onisthe return on capital. lent factors the value of funds If the return on capital decreases by a certain paid by the borrower. percentage interest rates will have to decrease by the same amount in order to restore returns to capital to its original level. This way borrowers will want to borrow and invest the same amount as before the decrease.

With this example the return to capital has fallen by 2% as borrowers now need to pay 2% tax out of their profits. In order for the same amount of investment and borrowing to be undertaken borrowers will want 2% lower interest rates before tax. Hence on the loanable funds diagram the investment curve will shift down by 2% of the current interest rate.

A 2% tax on the value of funds lent paid by the borrower

Saving (supply of loanable funds) Interest rate (equilibrium)

2% shift down

Investment (demand for loanable funds) (equilibrium) Quantity of loanable funds

This shift in the investment curve caused the interest rate and the level of investment and saving to fall. This will decrease output and growth in the economy.

As before there are factors which effect the level of lending besides interest rates. These other factors lead to shifts in the savings curve given the axis we have plotted it against. value these factors is the A 2% tax on the One of of funds lent return to saving and the intuition is the same as the paid by the lender. previous example. If the return to saving decreases the interest rates will have to increase by the same amount so that savers will want to save and lend the same amount as before the decrease.

With this example the return to saving has fallen by 2%. In order for the same amount of saving and lending to be undertaken savers will want 2% higher interest rates before tax. The saving curve will shift up by 2% of the current interest rate.

A 2% tax on the value of funds lent paid by the lender

Saving (supply of loanable funds)
Shifts up by 2%

Interest rate (equilibrium)

Investment (demand for loanable funds) (equilibrium) Quantity of loanable funds

This shift in the savings curve caused the interest rate to rise and the level of investment and saving to fall. This will decrease output and growth in the economy. It can be therefore be seen that regardless of who pays the tax it has the same effect on the quantity of saving and investment in an economy.