Following the increase in government spending, Country Y finances a new defense program by issuing additional government bonds. In the short run, this increases the government budget deficit. Which statement best explains why the real interest rate tends to rise in the loanable funds market?
- The demand for loanable funds increases due to higher government borrowing, raising the equilibrium real interest rate. (correct answer)
- The supply of loanable funds increases because government deficits increase national saving, lowering the real interest rate.
- The real interest rate falls because higher government spending reduces inflation expectations in the short run.
- The real interest rate rises because the central bank sells bonds, which directly increases the demand for loanable funds.
- The real interest rate does not change because deficit spending only affects aggregate demand, not financial markets.
Explanation: Crowding out begins in the loanable funds market when government deficit spending increases the demand for loanable funds. When Country Y issues additional bonds to finance its defense program, the government becomes an additional borrower competing with private borrowers for the same pool of savings. This rightward shift in the demand for loanable funds raises the equilibrium real interest rate. A common misconception is that government deficits increase national saving (choice B), when actually deficits represent negative public saving that reduces total national saving. The transferable strategy remains: G↑ → i↑ → I↓, starting with government borrowing increasing demand for funds.