Macro Economics Hw4

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5. Use a supply and demand graph for loanable funds to explain crowd out. (Figure 3.3)

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The dashed line is investment and the solid line is starting line. The higher bold line means that interest rates are higher, so that the I dashed curve will hit the new interest rate at a lower level of investment (I1). Thus the government deficit raises interest rates and crowds out investment spending.

(a) Show how crowd-out is generated by the slope of the supply curve for loanable funds.

you draw two examples of the figure in 3.3, one with a very steep supply curve (where funds are not very forthcoming with higher interest) and one with a very shallow curve (where slight increases in i create large increases in the supply of funds). Walk through the analysis I gave above and show that the shallow curve means that shifting out the demand curve barely raises the interest rate, and so it barely decreases investment. The steep curve, on the other hand, gives you a very sharp rise in the interest rate and so a larger decrease in investment.

(b) Briefly discuss the benefits and risks of a large presence of international investors.

more international investors means that higher interest rates attracts not just domestic but foreign investment, so that loanable funds go up quickly with small rises in i. This means that the supply curve is shallow and so crowd out will be less severe. The risk is that the international investors are much more flighty, and so if they get spooked, the loanable funds supply could plummet and cause a huge rise in interest rates and a collapse of the credit market. This is the problem of _hot capital_.