Suppose the federal government is successful in reducing the budget deficit, households decide to increase their saving, corporate taxes are reduced, and businesses expect to see an increase in future profits

Use the loanable funds model to explain how each of these events affects the demand and supply of loanable funds and illustrate your answer with a graph. Describe what should happen to the equilibrium real interest rate and the equilibrium levels of saving and investment?

The reduction in the budget deficit and the increase in household saving will increase the supply of loanable funds, shifting the supply curve to the right. The decrease in corporate taxes and increase in expected future profits will increase the demand for loanable funds, shifting the demand curve to the right. The increase in supply will result in a decrease in the equilibrium real interest rate and an increase in the equilibrium levels of saving and investment. The increase in demand will result in an increase in the real equilibrium interest rate and an increase in the equilibrium levels of saving and investment. Therefore, when both supply and demand increase, the equilibrium levels of saving and investment should definitely increase, and the equilibrium real interest rate may increase, decrease, or remain unchanged, depending on the magnitude of the shifts in demand and supply. In the figure below, the supply shift is greater than the demand shift, so the equilibrium real interest rate decreases.