2) What is the crowding -out effect and how does it work? Use a graphical representation of the loanable funds market to illustrate your answer. (30 points)

The crowding-out effect refers to the phenomenon where an increase in government spending leads to a decrease in private sector spending. This happens because the government needs to borrow money to finance its spending, which increases the demand for loanable funds. As a result, the interest rate rises, making it more expensive for the private sector to borrow money. This leads to a decrease in private sector spending, as businesses and households are less likely to invest or consume when interest rates are high.<br /><br />To illustrate this using a graphical representation of the loanable funds market, we can show the market equilibrium before and after an increase in government spending.<br /><br />Before the increase in government spending, the market is in equilibrium at point A, where the supply of loanable funds (S) equals the demand for loanable funds (D). The equilibrium interest rate is r1, and the equilibrium quantity of loanable funds is Q1.<br /><br />After the increase in government spending, the demand for loanable funds increases, shifting the demand curve to the right. The new equilibrium is at point B, where the supply of loanable funds still equals the demand for loanable funds, but at a higher interest rate of r2 and a lower quantity of loanable funds of Q2.<br /><br />The increase in the interest rate from r1 to r2 makes it more expensive for the private sector to borrow money, leading to a decrease in private sector spending. This is the crowding-out effect, where the increase in government spending leads to a decrease in private sector spending.<br /><br />In summary, the crowding-out effect occurs when an increase in government spending leads to a decrease in private sector spending due to the increase in interest rates resulting from the increased demand for loanable funds.