Question

Initially, in a borrowing and lending market, or a loanable funds market, there is an equilibrium. Suppose entrepreneurs' aggregate expectations are that the economy is going to be good next year (i.e. opportunities for investment). What is likely to happen to the equilibrium interest rate under the following scenarios: 1. There is no change in the loan supply curve; 2. Potential lenders disagree with entrepreneurs, lenders view the future economic outlook as negative/riskier. Answer both cases using the theory of loanable fund markets.

Answer 1

Initially, in a borrowing and lending market, or a loanable funds market, there was an equilibrium and the entrepreneurs expect the economy to be good i.e. increase in opportunities for investment which says that the demand for loans will increase in near future.

The theory of the loanable funds market says that " the rate of interest for lending is determined by the demand for and supply of loanable funds"

1. As the main source of demand is a demand for investment which is likely to increase it will shift the demand curve towards right. The loan supply curve doesn't change as mentioned in the question. Hence, the equilibrium will shift upward i.e. the price of the funds which is the interest rate will increase.

2. Potential lenders disagreeing with entrepreneurs with having a pessimistic view will lead to a reduction of supply of funds in the market which will take the supply curve towards left. And the entrepreneurs have the opposite view which has already shifted the demand curve to right. So ultimately the new equillibrium interest rate will be much higher than the previous equillibrium interest rate.