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Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is $0.2 trillion. Assume that the economy is closed. (Consult Chapter 13, pages 269-270; 273-275)

  1. Calculate consumption, government purchases, national saving, and investment.

  2. Draw a diagram of real interest rates; the demand for loanable funds and the supply of loanable funds (define as the flow of resources available to fund private investment).

  3. Explain the shape of the demand for loanable funds and the shape of the supply of loanable funds.

  4. The government incurs a deficit of say two hundred million dollars and then instructs the Federal Reserve Board to sell ten year Treasury bonds in order to raise two hundred million dollars. Given that the deficit is the only change in this closed economy, use your diagram to explain: the shift in supply of loanable funds; the movements upwards or downwards of interest rates.

Explain under what conditions the incurring of a government deficit and subsequent borrowing by issuing bonds leads to a crowding out of private investment