These are original Marlbridge practice questions, not past exam questions. They use Valdoria, Kestria, Northmark and Southmark, fictional countries whose currency is the valda (VD); all data are fictional. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: each economy is closed (no international borrowing or lending); “interest rate” on a loanable funds graph means the real interest rate; government borrowing is the same at every interest rate; a four-function calculator is enough.
Question 1 (multiple choice · foundation)
Which of the following best describes crowding out?
- (A) Government purchases rise, so firms sell more and hire more workers.
- (B) Government borrowing raises the real interest rate, which reduces private investment spending.
- (C) The central bank buys government bonds, which lowers the interest rate and raises investment.
- (D) A government budget surplus raises the national debt and the interest payments on it.
Answer and explanation
Answer: (B). Crowding out is the fall in interest-sensitive private spending caused by the higher real interest rate that extra government borrowing brings.
- (A) describes the intended multiplier effect of fiscal policy, not the offsetting effect on private investment.
- (C) is expansionary monetary policy (Unit 4). It lowers interest rates, the opposite of crowding out.
- (D) is wrong twice: a surplus reduces the national debt, and crowding out is about borrowing, not debt interest.
Question 2 (multiple choice · core)
Valdoria’s government increases its budget deficit and borrows to finance it. Other things equal, what happens in the loanable funds market?
- (A) The real interest rate rises, the total quantity of loanable funds rises and private investment falls.
- (B) The real interest rate rises, the total quantity of loanable funds falls and private investment rises.
- (C) The real interest rate falls, the total quantity of loanable funds rises and private investment rises.
- (D) The real interest rate is unchanged, because savers supply exactly the extra amount the government borrows.
Answer and explanation
Answer: (A). Extra government borrowing shifts the demand for loanable funds right. The real interest rate rises; savers move up the supply curve, so the total quantity rises; private borrowers move up the original demand curve, so private investment falls.
- (B) gets the quantity and investment backwards. With a rightward demand shift, the total quantity rises, and a higher real interest rate reduces, not raises, private investment.
- (C) treats the shift as if supply had increased. More borrowing raises the price of borrowing.
- (D) ignores the shortage at the old rate. Savers supply more only if the real interest rate rises.
Question 3 (multiple choice · core)
A rise in the real interest rate caused by government borrowing is most likely to reduce which of the following?
- (A) Spending on groceries by households
- (B) Government transfer payments to retired people
- (C) A firm’s purchase of new machinery financed by a bank loan
- (D) The quantity of loanable funds supplied by savers
Answer and explanation
Answer: (C). Business investment financed by borrowing is interest-sensitive: a higher real interest rate makes fewer projects worth the cost of the loan.
- (A) Everyday spending on food is rarely financed by borrowing, so it responds little to interest rates.
- (B) Transfer payments are set by government policy, not by the interest rate, and they are not private spending.
- (D) A higher real interest rate increases the quantity of loanable funds supplied (a movement up the supply curve).
Question 4 (multiple choice · core)
Kestria runs large budget deficits for many years, and crowding out reduces private investment each year. Compared with a situation with no crowding out, what is the most likely long-run effect?
- (A) The long-run aggregate supply curve shifts right by less, because the capital stock grows more slowly.
- (B) The long-run aggregate supply curve shifts left, because the price level rises.
- (C) Real GDP per capita grows faster, because government purchases are part of GDP.
- (D) There is no long-run effect, because crowding out affects only aggregate demand.
Answer and explanation
Answer: (A). Less private investment means less physical capital per worker, so productivity and potential output grow more slowly. LRAS still tends to shift right, but by less.
- (B) confuses a change in the price level with a change in capacity. The price level does not shift LRAS.
- (C) looks only at the short-run spending effect. The long-run effect of lower investment is slower growth.
- (D) ignores that investment builds the capital stock, which determines future capacity.
Question 5 (calculation · core)
In Kestria’s loanable funds market (VD billion a year, r in %), private demand is Qd = 520 − 30r and supply is Qs = 120 + 50r. The budget is balanced. Then the government runs a deficit and borrows VD 80 billion.
(a) Calculate the equilibrium real interest rate and quantity of loanable funds before the deficit. (b) Calculate the new equilibrium real interest rate and quantity. (c) Calculate the amount of private investment crowded out, and the increase in saving.
Worked solution
(a) 520 − 30r = 120 + 50r, so 400 = 80r and r = 5%. Q = 120 + 50(5) = VD 370 billion.
(b) New demand = 600 − 30r. 600 − 30r = 120 + 50r, so 480 = 80r and r = 6%. Q = 120 + 50(6) = VD 420 billion.
(c) Private investment at 6% = 520 − 30(6) = VD 340 billion, down from VD 370 billion: VD 30 billion crowded out. Saving rises from 370 to 420: VD 50 billion. Check: 30 + 50 = 80, the amount the government borrows.
Suggested mark points (3): 1 for r = 5% and VD 370 billion; 1 for r = 6% and VD 420 billion; 1 for VD 30 billion crowded out with the VD 50 billion rise in saving. A common error is to say all VD 80 billion is crowded out; that loses the third point.
Question 6 (constructed response · core)
Valdoria is in a recession. Its government increases purchases of goods and services and finances the extra spending by borrowing.
(a) Draw a correctly labelled graph of the loanable funds market. Show the effect of the extra borrowing, labelling the original and new real interest rates r₁ and r₂. (b) Explain how the change in (a) affects private investment. (c) Explain why the increase in aggregate demand will be smaller than the spending multiplier alone predicts. (d) Explain one possible long-run effect of the change in (b) on Valdoria’s economic growth.
Model answer and suggested Marlbridge rubric
(a) Vertical axis: real interest rate. Horizontal axis: quantity of loanable funds. Upward-sloping S, downward-sloping D₁, and D₂ to the right of D₁. The intersection moves up along S, so r₂ is above r₁. (Alternative: S shifts left because public saving falls, with r₂ above r₁.)
(b) The higher real interest rate raises the cost of borrowing. Firms find fewer investment projects worth financing, so private investment falls (a movement up the original demand curve).
(c) Investment is a component of aggregate demand. The fall in investment partly offsets the rise in government purchases, so the net rightward shift of AD is smaller than the multiplier times the rise in government purchases.
(d) Lower investment means a smaller stock of physical capital in the future. Workers have less capital to work with, productivity grows more slowly, and LRAS shifts right by less, so long-run growth is slower.
| Point | What earns it |
|---|---|
| 1 | Correctly labelled loanable funds graph (real interest rate on the vertical axis, quantity of loanable funds on the horizontal axis, S and D) |
| 1 | Demand shifts right (or supply shifts left) with r₂ above r₁ |
| 1 | Higher real interest rate reduces private investment |
| 1 | Lower investment, a component of AD, offsets part of the rise in government purchases |
| 1 | Lower investment → less physical capital → slower growth (LRAS shifts right by less) |
Accept “interest rate” or “r” on the vertical axis of a loanable funds graph. A money market graph, or an axis labelled “nominal interest rate”, does not earn the first point. Shifting both curves loses the second point.
Question 7 (constructed response · stretch)
Northmark and Southmark start with the same private demand for loanable funds, Qd = 300 − 10r (VD billion, r in %). Their supply curves differ:
- Northmark: Qs = 200 + 10r
- Southmark: Qs = 50 + 40r
Both start with a balanced budget. Each government then borrows VD 40 billion.
(a) Show that both countries start at the same equilibrium. (b) For each country, calculate the new real interest rate and the amount of private investment crowded out. (c) Explain why the amount crowded out differs between the two countries.
Model answer and suggested Marlbridge rubric
(a) Northmark: 300 − 10r = 200 + 10r gives r = 5%, Q = 250. Southmark: 300 − 10r = 50 + 40r gives r = 5%, Q = 250. Both start at r = 5%, VD 250 billion.
(b) New demand = 340 − 10r.
- Northmark: 340 − 10r = 200 + 10r, so r = 7%. Private investment = 300 − 70 = 230, so VD 20 billion is crowded out (half of the borrowing).
- Southmark: 340 − 10r = 50 + 40r, so 290 = 50r and r = 5.8%. Private investment = 300 − 58 = 242, so VD 8 billion is crowded out (one-fifth).
(c) In Southmark, saving responds much more to the real interest rate (a flatter supply curve). A small rise in r brings out a lot of extra saving (VD 32 billion), so the government’s borrowing is mostly met by new saving and the rate rises only a little. In Northmark, saving responds weakly, so r must rise further, and more of the government’s borrowing is met by pushing out private borrowers.
| Point | What earns it |
|---|---|
| 1 | Shows both equilibria are r = 5%, VD 250 billion |
| 1 | Northmark: r = 7%, VD 20 billion crowded out |
| 1 | Southmark: r = 5.8%, VD 8 billion crowded out |
| 1 | Explains that the more responsive supply of saving limits the rise in r and so limits crowding out |
Accept answers to (c) that use slopes (“steeper supply curve”) if they link the slope to the size of the rise in r.
How did you do?
- Q1 or Q3 wrong: re-read “Why a deficit means borrowing” and the chain in “How government borrowing crowds out private investment” in the study guide.
- Q2, Q5 or Q6(a)–(b) wrong: work through Worked example 1 and Figure 1 again.
- Q4 or Q6(c)–(d) wrong: revisit Worked example 2 and Figure 2.
- Q7 wrong: revisit “What makes crowding out bigger or smaller”.
Then tick off the topic checklist.