Exhibit: Saving, Investment, and the Interest Rate 1

The economy begins in equilibrium at point E, representing the real interest rate r1 at which saving S1 equals desired investment I1. What will be the new equilibrium combination of real interest rate, saving, and investment if the government increases spending, holding other factors constant?

Question

Exhibit: Saving, Investment, and the Interest Rate 1

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The economy begins in equilibrium at point E, representing the real interest rate r1 at which saving S1 equals desired investment I1. What will be the new equilibrium combination of real interest rate, saving, and investment if the government increases spending, holding other factors constant?

BlackTom AI · Accepted Answer

Let's break down what happens when the government increases spending, holding other factors constant, in a loanable funds framework where saving (S) is vertical segments and investment (I) depends on the real interest rate.

- Option A: point A (at S2 and r2)
This would imply that the economy moves to a higher saving level S2 and a higher real interest rate r2, with the intersection aligning somewhere along the savings schedule S2. The key issue is whether an increase in government spending alone would raise saving to this new level and push the interest rate up to r2. In a standard crowding-out scenario, higher G raises demand for funds, pushing up the interest rate and crowding out some private investment, but the saving schedule shift needed to reach A is not the most direct consequence of only a fiscal expansion, since saving is typically determined by income and other factors, not instantly jumping to S2 without a corresponding shift in other determinants. Therefore A is not the most consistent depiction of the typical crowding-out mechanism.

- Option B: point B (at S3 and r? on the vertical line crossing the investment curve)
Point B places us at the far right saving level S3, implying a large increase in saving, but on many diagrams the crowding-out effect tends to move us along a higher interest rate with the investment demand downward-sloping crossing a higher r. If S3 is achieved, the corresponding r would be determined by where the investment demand intersects, which would typically be higher than the original r1. However, simply selecting B would require assuming a specific r-value that may not align with the standard crowding-out dynamics shown in the graph as the new equilibrium point.

- Option C: point C (at S2 and r3)
Point C sits on the left-of-center saving level S2 with a relatively low r3. In this graph, moving from the initial equilibrium E (with r1) to a higher government spending scenario generally increases the demand for funds, pushing up the real interest rate. At the same time, the increase in government spending tends to depress private investment, and depending on the relative shifts, saving can be routed toward a higher or lower r depending on income response. In this particular diagram, the suggested new equilibrium aligning with a higher crowding-out pressure ends up at C, where saving is at S2 (a higher saving than S1 but not the maximum S3) and the real rate is elevated to r3 relative to r1. Therefore C fits the typical outcome of higher G increasing the interest rate and altering saving slightly upward from the initial level, consistent with the crowding-out narrative.

- Option D: point D (at S3 and r1)
This point would indicate a higher saving level S3 but the same real interest rate as before (r1). That would imply an automatic mechanism where increased government spending does not affect the real rate, which contradicts the core investment-savings interaction in the loanable funds framework. A higher government spending without a corresponding rise in the interest rate would not reflect the crowding-out effect, so D is inconsistent with the standard outcome depicted here.

In summary, examining how fiscal expansion shifts the interaction of saving and investment in the diagram shows that the equilibrium moves from E to a new intersection characterized by a higher interest rate and a save/investment configuration consistent with a higher crowding-out effect. Among the options, point C most coherently represents that adjusted equilibrium, given the positions of saving S2 and the higher rate r3 on the graph.

ECON 4002.01 SU2025 (11437) Exam 1

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