Question

The French Government runs a budget deficit and finances it by borrowing $20 billion. Use the loanable fund model to show the decline in public savings and decline in investments (crowding out).

Answer 1

Answer: Please refer to explanation

Explanation:

The Loanable Find model attempts to explain the movement in interest rate as a function of supply and demand.

Now, if more people are looking for loans (demand increases) and supply remains the same, the demand curve is forced to shift to the right. This increases the Equilibrium interest rate.

This increased Interest rate then leads to a CROWDING OUT effect because the private sector will reduce it's borrowing as it cannot borrow at such high rates.

This is what will happen should the French government borrow such a large amount especially if the economy is operating at FULL CAPACITY. They will INCREASE the demand for loans and therefore CROWD OUT the private sector.

I have included a graph to explain it more.

If you have need for any clarification do react or comment.