Financing the Deficit
The question
The government of Alta begins running a budget deficit and enters the loanable funds market, issuing new bonds to borrow the funds it needs. Assume that private saving at each real interest rate is unchanged. Show the effect of the government's borrowing in the 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.
Financing the Deficit: the worked answer
On the Loanable Funds Market graph, Demand for loanable funds shifts right.
Why Demand for loanable funds shifts right
Borrowers make up the demand for loanable funds, and the government's bond issuance makes it a new borrower in the market. At every real interest rate, the total quantity of funds demanded is now higher because government borrowing is added to private investment borrowing. The demand for loanable funds shifts to the right, while the supply of saving is unchanged by assumption.
What happens to the equilibrium
The equilibrium real interest rate rises and the equilibrium quantity of loanable funds increases.
The mistake students make on this one
Many students shift the supply of loanable funds left instead, reasoning that government borrowing takes funds away from private borrowers. The government here is a borrower, not a lender, so its new bonds add to the borrowing side; the crowding out of private investment shows up as the higher interest rate reducing the quantity of funds firms borrow along their own unchanged demand schedule, not as a leftward shift of supply.
On exam day
Decide first whether the government is raising money or returning it. Issuing new bonds puts the government on the borrowing side of the graph, and running a surplus to retire debt puts it on the lending side.
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 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.
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