Question

At the interest rate of 5%, the people of the country of Rupertopia are willing to lend $10,000 to local business, while local businesses are willing to borrow $20,000. When the interest rate rises to 10%, the quantity of loans supplied increases to $20,000, while the quantity of loans demanded drops to $10,000. Because the people of Rupertopia are suspicious of outsiders, all financial transactions happen between locals. Assume both supply and demand curves for loanable funds are linear.

Peter hopes to borrow money to open a factory in town. Given the above information and holding everything else constant, what is the interest rate Peter will pay for the loan.

Answer 1

As the interest rate increases from 5% to 10%, quantity supplied of loanable funds increases from $10,000 to $20,000.

It can be seen that 100 percent increase in interest rate leads to 100 percent increase in quantity supplied of loanable funds.

Since, supply curve of loanable funds is linear, a 50 percent increase in interest rate will lead to 50 percent increase in the quantity supplied of loanable funds.

So, if interest rate increases from 5% to 7.5% then quantity supplied of funds will increase from $10,000 to $15,000.

As the interest rate increases from 5% to 10%, quantity demanded of loanable funds decreases from $20,000 to $10,000.

It can be seen that 100 percent increase in interest rate leads to 100 percent decrease in quantity demanded of loanable funds.

Since, demand curve of loanable funds is linear, a 50 percent increase in interest rate will lead to 50 percent decrease in the quantity demanded of loanable funds.

So, if interest rate increases from 5% to 7.5% then quantity demanded of loanable funds will decrease from $20,000 to $15,000.

Thus, quantity demanded and quantity supplied of loanable funds will equal to each other at interest rate of 7.5%.

Thus, the equilibrium interest rate is 7.5%.

So, the Peter will pay interest rate of 7.5% for the loan.