Investment Tax Credit: The Real Rate Rises
A tax credit on new capital raises the after-tax return to investing, shifting the demand for loanable funds right and pushing the real interest rate up.
Investment Tax Credit: The Real Rate Rises
Loanable Funds MarketA tax credit on new capital raises the after-tax return to investing, shifting the demand for loanable funds right and pushing the real interest rate up.
Equilibrium at Quantity of Loanable Funds 73, Real Interest Rate (%) 5
Start at Equilibrium
The loanable funds market opens in equilibrium. The vertical axis measures the real interest rate, the return savers earn and borrowers pay after inflation, and the horizontal axis measures the quantity of funds. Demand comes from firms and households borrowing to finance capital projects; supply comes from savers. Their intersection sets the real interest rate and the quantity of funds borrowed and lent.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Investment Tax Credit: The Real Rate Rises, step by step
- 1
Start at Equilibrium
The loanable funds market opens in equilibrium. The vertical axis measures the real interest rate, the return savers earn and borrowers pay after inflation, and the horizontal axis measures the quantity of funds. Demand comes from firms and households borrowing to finance capital projects; supply comes from savers. Their intersection sets the real interest rate and the quantity of funds borrowed and lent.
- 2
The Credit Raises After-Tax Returns
The credit refunds part of the price of every new machine and building, so a project that used to just miss being worthwhile now clears the bar. At every real interest rate firms want to finance more investment, so the demand for loanable funds shifts right. Nothing about saving behavior has changed yet, so the supply curve stays put.
- 3
The Real Interest Rate Rises
More borrowers now compete for the existing pool of saving, so the equilibrium slides up along the supply curve. The real interest rate rises and the equilibrium quantity of funds borrowed and lent increases.
- 4
Saving Rises Along the Supply Curve
The higher real interest rate rewards lending, so households and firms supply more funds. That extra saving is a movement up along the supply curve, not a rightward shift of it. Investment finishes higher than it started, financed by the saving the higher real interest rate called forth. On an exam, draw the one shift and explain everything else as movement along a curve.
Where it ends up
An investment tax credit raises the demand for loanable funds, so both the real interest rate and the equilibrium quantity of funds rise.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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