Question

The following functions pertain to the loanable funds market of a hypothetical country:
DL= 41 - 7r
SL = 5 + 2r
DL = SL
Where DL is demand for loanable funds, SL is supply of loanable funds and r is the real interest rate.
a) Find the equilibrium values of r, DL and SL.
b) If there is GHȼ81 million-bond financed increase in government expenditure, find:
i) The new equilibrium values of r, DL and SL.

Answer 1

Solution:

a.) Equilibrium: DL = SL

$DL = SL$

$41-7r = 5+2r$

$41-5=2r+7r$

$36 = 9r$

$r=\frac{36}{9}$

$r = 4$

b.) An increase in government expenditure by GHȼ81 million-bond will lead to an increase in demand for loanable funds due to high interest rate incurred and an increase in supply of loanable funds.

New demand equation will be:

$41-81-7r = -40-7r$

New supply function will be:

$5+81+2r =86+2r$

New equilibrium will be:

DL = SL

$-40-7r=86+2r$

$-40-86=2r+7r$

$-126=9r$

$r=\frac{-126}{9}$

$r=-14$