Deficit Meets Retirement Wave
The question
The government of Sabreth begins running a budget deficit and issues new bonds to cover the shortfall. Over the same years, an unusually large generation reaches retirement age, stops earning wages, and starts spending down the wealth it built up over a working lifetime. Show the effect of these two developments in Sabreth's loanable funds market. Show the effect on the Loanable Funds Market graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Deficit Meets Retirement Wave: the worked answer
On the Loanable Funds Market graph, Demand for loanable funds shifts right and Supply of loanable funds shifts left.
Why Demand for loanable funds shifts right and Supply of loanable funds shifts left
Borrowers make up the demand for loanable funds, and a government that issues new bonds to cover a deficit becomes a borrower in this market, so the total quantity of funds demanded at every real interest rate is higher and the demand for loanable funds shifts right. The supply of loanable funds is national saving, and retirees who have stopped earning wages and are drawing down accumulated wealth are dissaving, so fewer funds are offered to borrowers at every real interest rate and the supply of loanable funds shifts left. Both shifts push the same way on the vertical axis, because more borrowing bids the real interest rate up and less lending bids it up as well, so the equilibrium real interest rate definitely rises. The two shifts push in opposite directions on the horizontal axis, because the added government borrowing raises the quantity of funds changing hands while the shrinking pool of saving lowers it. The equilibrium quantity of loanable funds is therefore indeterminate: it rises if the rightward shift of demand is larger than the leftward shift of supply, falls if the shift of supply is larger, and is unchanged if the two are equal in size. Nothing in the stem says which is larger, so the quantity cannot be signed.
What happens to the equilibrium
The equilibrium real interest rate definitely rises, while the equilibrium quantity of loanable funds is indeterminate because it depends on whether the increase in borrowing or the decrease in saving is the larger shift.
The mistake students make on this one
The dominant wrong answer is to report both outcomes as determinate, almost always as "the real interest rate rises and the quantity of loanable funds rises," because government borrowing is the headline event and students carry over the answer from the single-shift deficit question. Only the interest rate has a determinate direction here. Demand shifting right raises the quantity and supply shifting left lowers it, and the stem gives no information about the relative sizes, so any signed claim about quantity is unsupported. The other common failure is to draw only the deficit and leave the saving side untouched, which turns a two-shift question into a one-shift answer and gives up the second shift point outright.
On exam day
Check each axis on its own before you write a word: name a direction only where the two shifts push the same way, and where they conflict write the word indeterminate and say what it depends on, because rubrics award that point for the explicit statement and never for a hedge.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Demand for loanable funds shifts right and Supply of loanable funds shifts left and every other curve on the Loanable Funds Market graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
More Loanable Funds Market scenarios
Last updated