Question

Assume that the demand for lending by financial institution increases significantly because of a booming economy and business activities. Also, assume that the fed is not interested in intervening to support the increase in demand for lending by banks. what change do you expect to see in the direction of the short term interest rate? will it increase, decrease or stay the same? explain, briefly, with the help of a relevant diagram, the federal fund market.

Answer 1

Interest rates are nothing but the expense of the borrower for using someone elses funds and the income of the lender for allowing the borrower to use such funds.The lenders or finalncial instituions lending money form the supply side of the federal funds market whereas the people/firms borrowing the funds form the demand side of the market.

Interest rates are affected by the state of demand and supply in the federal funds market. The equilibrium rate of interest is the rate at which the demand for lending is equal to the supply of funds in the market. Whenever there is an increase in demand for money the market rate of interest rises and the opposite happens when the demand for such funds decreases. Similarly when the supply for funds rises, interest rates fall (due to excess supply over demand) and supply of funds fall, interest rate increases(as there is more demnd than what is supplied)

This mechanism decides the interest rates , only when the governement doesnt intervene.

The same can be shown using the graph below:

Here in the graph, the intial Demand curve id Demand 1,and the equilibrium rate of interest is i. As the demand for funds rises, the demand curve now shifts to Demand 2 . In this scenario their is not intervention of the government,neither there is rise in supply of funds. In such a condition the interest rate rises to i2.

This phenomenon is a short term mechanism. In the long term , when interest rate rises, supply for funds also rise, to interact with demand curve to form a new equilibrium interest rate.