Question

Using the loanable funds theory and the demand and supply of loanable funds, explain what will happen to the real interest rate in an economy if a recession occurs, such as occurred with the Covid19 pandemic.

Answer 1

When an economy is in a recession, government responds by increasing government spending and decreasing the tax rate. This increases government's budget deficit.

Now there can be two scenarios:

Increase in budget deficit increases demand for loanable funds (government issues bonds and demand loanable funds to pay for it's deficit). This will shift the demand curve rightward in the loanable funds market. As a result, equilibrium real interest rate increases.

Increase in budget deficit means national savings decreases. This will decrease the supply of loanable funds, shifting the supply curve leftward in the market for loanable funds. As a result, equilibrium real interest rate increases.

So no matter what the scenario is, equilibrium real interest rate will increase.