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

In each graph, Interest rate (P) is measured vertically and quantity of loanable funds (Q) is measured horizontally. D0 & S0 are initial demand & supply curves for loanable funds, intersecting at point A with initial interest rate P0 and initial quantity of loanable funds Q0.

(1) Decrease in money supply lowers aggregate demand, which decreases savings. Lower savings decreases the supply for loanable funds, shifts the supply curve leftward and increasing interest rate but decreasing the quantity of loanable funds. In following graph, as S0 shifts left to S1, it intersects D0 at point B with higher interest rate P1 and lower quantity of loanable funds Q1.

(2) Large deficit financing increases the demand for loanable funds, shifts the demand curve rightward and increasing both interest rate and quantity of loanable funds. In following graph, as D0 shifts right to D1, it intersects S0 at point B with higher interest rate P1 and higher quantity of loanable funds Q1.

(3) If firms lower growth prospects, the decrease investment, shifts the demand curve leftward and decreasing both interest rate and quantity of loanable funds. In following graph, as D0 shifts left to D1, it intersects S0 at point B with lower interest rate P1 and lower quantity of loanable funds Q1.

(4) Higher wealth and liquidity increases savings. Higher savings increases the supply for loanable funds, shifts the supply curve rightward and decreasing interest rate but increasing the quantity of loanable funds. In following graph, as S0 shifts right to S1, it intersects D0 at point B with lower interest rate P1 and higher quantity of loanable funds Q1.

(5) Greater risk aversion lowers business investment, shifts the demand curve leftward and decreasing both interest rate and quantity of loanable funds. In following graph, as D0 shifts left to D1, it intersects S0 at point B with lower interest rate P1 and lower quantity of loanable funds Q1.