Question

Under the loanable funds theory, the equilibrium interest rate is determined by the interaction between the demand for and the supply of funds from financial market participants, mainly the household sector, the business sector and the government sector.

Holding other factors constant, predict the change in domestic interest rates that would occur when facing each of the following situations. Explain your predictions in detail.
i The total wealth of local financial market participants increases.
ii The default risk of loans decreases.
iii Domestic economic growth is thriving.
iv Economic conditions in foreign countries improve.

Answer 1

Solution

1.The total wealth of local financial market participants increases - That means all the financial market participants will have more disposable income in their hands.So,the demand for loanable funds will decrease.So,the interest rates will decrease.

2. The default risk of loans decreases - When the default risk of the loans decrease,the interest rates would fall (decrease) because :

Total Risk = Default Risk + Risk Premium

The higher the risk ,the higher would be interest demanded by the lenders. Risk means the probability of variance in the payment

3.Domestic economic growth is thriving - This means the GDP / aggregate output will increase due to which the demand for loanable funds will increase from the business sector they need to invest in increasing their capacity in order to support the increase in aggregate demand.

So,the interest rates will increase.

4. Economic conditions in foreign countries improve - This results in the GDP / output increasing in other countries due to which the interest rates across the countries will increase by a small margin.

If the domestic factors are considered to be remaining constant,more investments will move to foreign countries instead of remaining / coming to the domestic country,leading to depreciation of currency of the domestic country.So,the local interest rates will also increase since the value of currency has decreased due to which the prices of goods will increase.

So,the interest rates has to increase due to multiple reasons - increase in the default risk in the local / domestic market which demands higher interest rates for loanable funds ; people will be ready to lend their money to businesses instead of having with them / or spending only if the interest rates offered on their investments is more than the inflation rate / increase in the level of prices of the goods and services

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