Question

Using the loanable Funds theory, show in a graph how the following event affects the supply and demand for loans and the equilibrium real interest rate. Explain in words as well:

There is a sudden increase in confidence of the economy from abroad, and the country receives sudden large capital inflows.

Answer 1

E0 is the initial equilibrium where demand (D) and supply (S) meet. The corresponding quantity is Q0 and real interest rate is I0.

Now, foreign confidence increases. It increases business confidence (opportunity) too in the domestic country. The demand curve shifts to the right as D1. As the supply of money increases because of capital inflows, it shifts the supply curve to the right as S1. The net effect is the increase in loanable funds (Q1) for quite sure; but the rate of interest depends on the gap of shifting – if the shifting gap of demand is higher than supply, the interest rate would increase (as it happens at E1 equilibrium, where the corresponding I1 indicates the increase in interest rate), if the shifting gap of supply is higher than demand, the interest rate would fall, and if the shifting gap of demand is just equal to supply the interest rate would stay unchanged.