Question

Show a loanable funds graph with a negative equilibrium interest rate. What kind of surplus or shortage exists if the ZLB binds?

Answer 1

Question: Show a loanable funds graph with a negative equilibrium interest rate. What kind of surplus or shortage exists if the ZLB binds?

Answer: in classical model interest rate are determined by real factors like demand and supply of capital. According to classical ROI is a real phenomenon. In Keynesian analysis interest rate is determined by demand for and supply of money. According to keynes ROI ( rate of interest) is purely a monetary phenomenon.

Demand for money arises for three motives

1 .transaction motive Td=f(Y)

2. Precautionary motive Pd= f(Y)

3. Speculative motive Sdm = f(r)

According to keynes transaction demand for money depends on income and not on interest rate that is Tdm is interest inelastic while post Keynesian Baumal and tobin shows that Tdm is interest elastic. In the loanable fund theory we can observe most important determinants are investment , interest rate, saving

There is negative relationship between interest rate and investment and there are multiplier effect can be seen between income and investment means if investment increases than income increases multiple times. Which can be shown from below diagram.

At very low rate of interest that is suppse at 2% speculative demand for money perfectly elastic known as liquidity trap.

Higher the rate of interest lower the speculative demand for money and vice versa. In liquidity trap situation people prefer to keep money in cash rather than invest in bonds. At liquidity trap situation crowding out effect is zero. When ROI is low, yield on bonds equities and other securities will be low. If ROI become zero than risk of loss in holding bonds become greater. Liquidity trap situation explain with the help of diagram given below.

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