Question

Discuss the loanable funds interpretation for IS curve

Answer 1

Loanable funds. The term loanable funds is used to describe funds that are available for borrowing. Loanable funds consist of household savings and/or bank loans. Because investment in new capital goods is frequently made with loanable funds, the demand and supply of capital is often discussed in terms of the demand and supply of loanable funds.

It is possible to suggest an alternative interpretation of the IS curve by referring to the dual role of the rate of interest in the circular flow model of national income.

Prima facie, the interest rate affects the supply of and demand for goods and services..

derive the IS curve from the equilibrium condition in the market for loanable funds. The IS curve shows the interest rate that brings about equilibrium in the market for loanable funds, income remaining constant. When income rises from Y1 to Y2 national saving (S) = Y – C – G increases but by less than Y since MPS < 1.

Fig (a) shows that the increased supply of loanable funds pushes down the rate of interest from r1 to r2. As a result investment and income increase. Fig (b) shows that an increase in income (which implies higher saving) implies a low equilibrium rate of interest. Due to this inverse relation between r and Y, the IS curve slopes downward from left to right.

In this case also a change in fiscal policy will shift the IS curve. If G increases, or T falls, S will fall if Y remains constant.

S = Y? – C (Y – T) - G = I

A cut in T will increase C and reduce Y? – C – G, The consequent fall in the supply of loanable funds raises r and equilibrates the market for loanable funds. Since r is now higher at a fixed level of Y, the IS curve shifts upward in response to the expansionary fiscal policy (which works through an increase in G or a cut in T or both at the same time). Thus the IS curve is a relationship between Y and r arising from either the commodity market or the market for loanable funds.