# discussionsectionhandout7answersfall2007 - Econ 102 Fall...

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Econ 102: Fall 2007 Discussion Section Handout #7 Question #1 Consider the market for loanable funds in Odiland, with demand and supply given by: D: i = 36 – (.2)I S: i = (.05)I where i is the interest rate (in percent) and I is the level of investment (in millions). a) Find the market equilibrium interest rate and level of investment. Setting our D and S equations equal to each other, we have 36 – (.2)I = (.05)I, so 36 = (.25)I, so I* = 144, and i* = (.05)I* = .05 x 144 = 7.2. Now the Odiland government has decided to build a dam. Originally, the Odiland government budget was balanced, but this project will give the government a deficit of \$20 million. b) Give the equations for the new supply and demand curves after the government decides to build the dam. Supply is unchanged, as the government is running a deficit. Demand shifts right by 20 units, so we have D: i = 36 – (.2)(I – 20) = 36 – (.2)I + 4 = 40 – (.2)I S: i = (.05)I c) Solve for the new market equilibrium interest rate and total investment. Following the same procedure as in a), we have 40 – (.2)I = (.05)I, so 40 = (.25)I, so I* = 160, i* = (.05)I* = .05 x 160 = 8. d) How much private investment has been “crowded out” by the government deficit? At an interest rate of 8%, private investment demand is 8 = 36 – (.2)I, so 28 = (.2)I, so I = 140. Since private investment before the government deficit was 144, we see that \$4 million worth of private investment has been crowded out by the deficit. e) Assume that Odiland has a closed economy. How much does household consumption fall as a result of the government deficit if total output and net taxes remain the same? With a closed economy, there are no imports or exports.

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