8 The Market for Loanable Funds
8.1 financial markets
Review Activities
Practice Problems
No practice problems for this section.
External Resources
Khan Academy: Stocks versus Bonds (this goes into more detail than you need)
8.2 Savings and investment
Review Activities
Practice Problems
No practice problems for this section.
External Resources
Khan Academy: National Savings and Investment
8.3 Interest and the market for loanable funds
Review Activities
Practice Problems
Problem 8.3.1: Suppose that the current inflation rate is 4%. Tom wants to get a loan to buy a car. The bank decides that based on Tom’s risk, they want to earn a real return of 5%. What nominal interest rate should they charge him? Suppose that over the course of the loan the inflation rate actually turns out to be 6%. What was their real rate of return on the loan?
Answers: 9%; 3%
Problem 8.3.2: Draw the market for loanable funds in a state of equilibrium. Be sure to label all components.
Answer: See video for graph.
External Resources
Khan Academy: Introduction to Interest (Ignore compound interest.)
Khan Academy: Real and Nominal Return
Khan Academy: Nominal Interest, Real Interest, and Inflation Calculations
8.4 shifts in demand and supply for Loanable funds
Review Activities
Practice Problems
Problem 8.4.1: A new government program allows people to save money tax-free. Graphically show the impact of this new policy on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes an increase in the supply of loanable funds (outward shift of supply). This causes a surplus of loanable funds. Therefore, the real interest rate falls. This results in a decrease in the quantity supplied of loanable funds and an increase in the quantity demanded for loanable funds. The new equilibrium interest rate is lower than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is greater than the original equilibrium quantity of loanable funds.
Problem 8.4.2: Businesses find that investment projects are more profitable and therefore increase the number of projects conducted. Many of these projects require loans to complete. Graphically show the impact of this new business strategy on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes an increase in the demand for loanable funds (outward shift of demand). This causes a shortage of loanable funds. Therefore, the real interest rate rises. This results in a decrease in the quantity demanded of loanable funds and an increase in the quantity supplied for loanable funds. The new equilibrium interest rate is greater than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is greater than the original equilibrium quantity of loanable funds.
Problem 8.4.3: Consumers become pessimistic about the future of the economy and choose to make less large purchases. This means that people are buying less things that require loans. Graphically show the impact of this new consumption pattern on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes a decrease in the demand for loanable funds (inward shift of demand). This causes a surplus of loanable funds. Therefore, the real interest rate decreases. This results in a decrease in the quantity supplied of loanable funds and an increase in the quantity demanded for loanable funds. The new equilibrium interest rate is less than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is less than the original equilibrium quantity of loanable funds.
Problem 8.4.4: The stock market is doing very well which means that people are choosing to put more of their money in the stock market and less into banks. Graphically show the impact of this new consumption pattern on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes a decrease in the supply of loanable funds (inward shift of supply). This causes a shortage of loanable funds. Therefore, the real interest rate increases. This results in a decrease in the quantity demanded of loanable funds and an increase in the quantity supplied for loanable funds. The new equilibrium interest rate is greater than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is less than the original equilibrium quantity of loanable funds.
Problem 8.4.5: The government engages in expansionary fiscal policy by increasing government spending and cutting taxes. This requires them to issue new debt. Graphically show the impact of this new government debt on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: The government will issue bonds to cover the new debt. This means that the government is going to take a larger share of natural savings meaning that there is less savings in the private sector. The result is a decrease in the supply of loanable funds (since people are putting their money into government debt instead of the bank). After the decrease in supply, there is a shortage of loanable funds causing real interest rates to increase (movement along the curves). The end result is an increase in the equilibrium real interest rate and an increase in the quantity of loanable funds.
External Resources
Khan Academy: Loanable Funds Market