Question

Do you believe that interest rates are largely determined by the supply and demand for lendable funds? Why or why not? What are a liquidity trap and helicopter money? Should long-term interest rates be higher or lower than short-term rates? Why? Who provides the supply of lendable funds, the rich or the poor? Who determines the demand for lendable funds?

Answer 1

The loanable fund theory of interest is the contribution of Neo-classical economist. According to them the rate of interest is determined by the demand for and supply of loanable fund. The demand for loanable fund comes from the sources like Investment, Hoarding and Dissaving. Likewise the supply of loanable fund comes from the sources namely Savings, Dishoarding, Disinvestment and Bank money. At a point where the demand for loanable fund equates with the supply of loanable fund the rate of interest is determined. The loanable fund is the money transacted in the money market. So the loanable fund has greater influence in determining the rate of interest.

The Liquidity trap is a concept introduced by J.M Keynes. The liquidity trap is a situation where the demand for money is perfectly elastic when the rate of interest reaches its lowest minimum. In this situation an increase in money supply is unable to lower the interest rate further. Whatever money supply is injected into the economy is hoarded by the people. This trap is related to the speculative demand for money. People use a part of income for speculative purposes like making profit by buying and selling bonds. At the lower interest rate the bond price will be high. At this situation people do not buy bonds. Any increase in money will be horded by the people in the expectation that the bond price will fall in future.

Helicopter money is the money printed and distribute in the economy during recession to stimulate the economy. By creating and distributing large amount of money the central bank attempts to increase consumer spending and increase the rate of inflation.

The long term interest rate is usually higher than the shorter interest rate. The rate of interest depends upon the term of bonds. Bonds with longer maturity usually pay higher rate of interest. The reason is that the long term bonds carry high risk in the event of inflation. The shorter bonds do not face such risk and its yield is comparatively low.

The components of the supply of loanable fund are savings, hoarding and disinvestment. The rich people save more as the propensity to consume is low with the increase in income. The hoarding is also done by the rich. Disinvestment is the undistributed profit retained by the corporate companies. All these are the contribution of rich.

The demand for loanable fund is determined by the investors, the people who hoard money and the people who spent money by borrowing.