Question

Using the loanable funds theory, explain what will happen to the real equilibrium interest rate under the following scenarios: (In your discussion describe or show with a graph the change in the supply curve for loanable funds and the change in its intersection with the demand curve for loanable funds).

(1) There is a decrease in the money supply with the Federal Reserve engaging in a contraction policy.

(2) The U.S. government has a large deficit that its need to finance, so will be issuing a large amount of new government bonds to sell to the public.

(3) There is a recession, and businesses are reducing their growth prospects.

(4) Wealth and liquidity in an economy increase.

(5) There is greater risk aversion in an economy.

Answer 1

Solutiom: As per lonable funds theory, equilibrium interest rate is determined at a point where demand curve and supply curve of lonable funds intersect each other that is when demand for and supply curve of lonable funds are equal.

The above figure shows that economy is initially in equilibrium at point E where demand for and supply of lonable funds are equal and the corresponding interest rate is r and Q is the equilibrium quantity of lonable funds.

(a)

A decrease in the money supply with the Federal Reaserve will reduce the supply of lonable funds. As a result, suppyly curve of the lonable funds will shift to left from SS to S''S''. New equilibrium is at point E". At E' real equilibrium interest rate will be higher than the initial rate.

(b)

Issue of large amount of new government bonds to sell to the public will lead to an increase in demand for lonable funds . Asa result, demand curve will shift to right from DD to D'D'. Economy will move from point E to E' and the equilibrium interest will rise as a result.

(c)

A recession will lead to fall in demand for lonable funds due to which demand curve will shift to left from DD to D''D''. Economy will move from point E to E" and the equilibrium interest will fall.

(d)

An increase in wealth and liquidity will lead to an increase in supply of lonable funds. Supply curve will shift to right from SS to S'S'. Economy will move from point E to E' and thus the equilibrium interest rate will fall as a result.