Question

1. Based on the loanable funds theory, explain how each of the following changes should impact interest rates (increase or decrease):
   1. Covenants on borrowing become more restrictive.
   2. The Federal Reserve increases the money supply.
   3. Total household wealth increases.

Answer 1

In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the interest rate is determined by the demand for and supply of loanable funds. It Includes all forms of credit including bonds, saving deposits etc.

If Demand for loanable funds increases, it increases the rate of interest, and if supply for loanable funds increases it decreases rate of interest and vice-a-versa.

A) If covenants in borrowing become more restrictive - If covenants in borrowings becomes more restrictive, this will reduce the demand for loanable money, and will lead to reduction in rate of interest.

B)The Federal Reserve increases the money supply - Interest rates fall when the money supply increases because the fact of an increased money supply makes it more plentiful

C)Total household wealth increases - If total household wealth increases, it will increase the savings and increase in savings (Savings deposits) leads to increase in supply of loanable funds which will result in decrease in interest rates.