Use the model of loanable funds to answer the following questions: In the long—run, how does a increase in government spending affect the real interest rate (I)? Include the appropriate diagram. How does the policy a?ect the levels of [i] national income (Y), (ii) consumption (C), and (iii) investment {I}? How do you know? (Note: assume that consumption depends only,r on disposable income.)

a. An increase in the government spending causes a rise in interest rates. Remember that an increase in government spending implies that there is more demand for loanable funds hence causing a shift to the right for the demand

Step-by-step explanation

a. An increase in the government spending causes a rise in interest rates. Remember that an increase in government spending implies that there is more demand for loanable funds hence causing a shift to the right for the demand. This causes a increase in r as shown in the diagram below from ro to r1.

Please see attached file

ii. National Income reduces. This is because of a concept called crowding out effect, where government borrowing in the local markets crowds out investments by raising the interest rates. In this case, at the high interest rates, there will be fewer investments and consumption hence a decline in the national income.

iii. Investment will decline- Due to the effect of crowding out, increasing government expenditure raises the interest rates and investments decline because it becomes expensive to invest at that high rate.

As mentioned earlier, persistent government spending implies a shift of the demand curve which in turn means that the rate of interest will rise. With a high interest rate, investment and consumption will decline as demonstrated in the diagram above through what has now come to be known as crowding out effect