Static LR Model

Loanable Funds Market

Mankiw, Chapter 3
Policy 1: Taxes and Saving
Tax policy may be used to affect saving.
Higher saving rate leads to higher GDP growth.
Consider tax policy that encourages saving.
Policy would shift supply of loanable funds.
Supply curve would shift outwards.
Result is lower interest rates and higher investment.
Little consensus on what tax policies most effective for
increasing saving.
Consumption tax, flat tax, expand IRAs, etc.

2
 Taxes and Saving
Interest
S1(r)
Rate
S2(r)
1

r1
2
r2

I(r)
3
0 L1 L2 Loanable Funds

3
Policy 2: Taxes and Investment

Investment tax credits reduce tax to firms undertaking new

investment.
Tax credit shifts demand for loanable funds by affecting incentive of
firms to borrow and invest.
Demand for loanable funds shifts outwards.
Effect on Market for Loanable Funds.
Higher interest rates and higher investment & saving.
higher savings occur as movement along the unchanged supply of
loanable funds.

4
 Taxes and Investment
Interest
S (r)
Rate

r2
2
r1 I2(r)
1

I1(r)
3
0 L1 L2 Loanable Funds

5
Policy 3: Govt Budget Deficits

Budget Deficit occurs when govt spends more than it receives.

Govt Debt is accumulation of past deficits.
Effects of increase in Budget Deficit.
Reduces Public Saving, so Supply of Funds falls.
Result is interest rate rises, savings/investment falls.
Called Crowding Out as govt displaces private invest.
Budget Deficits reduce economys growth rate over the long term.

6
Government Budget Deficits
Interest
S2(r) S1 (r)
Rate

1
r2
2 r
1

I1(r)
3
0 L2 L1 Loanable Funds