Loanable Funds Theory and Factors Affecting Interest Rates (Chapter Objectives)

Flashcards covering the Loanable Funds Theory, the components of demand and supply for loanable funds, equilibrium concepts, inflation and monetary policy effects, the Fisher effect, and forecasting frameworks.

Loanable Funds Theory

The market interest rate is determined by the supply of and demand for loanable funds.

Household demand for loanable funds

Households borrow to finance housing, automobiles, and household purchases; demand is inversely related to the interest rate.

Business demand for loanable funds

Businesses borrow funds; at a given interest rate, they demand more funds when rates are lower.

Government demand for loanable funds

Governments borrow when expenditures exceed revenues; demand is relatively inelastic to interest rates.

Foreign demand for loanable funds

A country’s demand for foreign funds depends on interest rate differentials with other countries.

Aggregate demand for loanable funds (DA)

The total funds demanded by all sectors (households, businesses, government, municipalities, foreigners) at a given interest rate.

Aggregate supply of loanable funds (SA)

The total funds supplied by all sectors plus the Fed, varying with the interest rate.

Equilibrium interest rate

The interest rate at which aggregate demand equals aggregate supply for loanable funds.

Surplus of loanable funds

Occurs when the interest rate is above the equilibrium, leading to excess supply.

Shortage of loanable funds

Occurs when the interest rate is below the equilibrium, leading to excess demand.

Fisher effect

Nominal interest rate i equals expected inflation plus the real interest rate: i = E(INF) + iR.

Impact of inflation on interest rates

Higher expected inflation shifts the demand and supply of funds, often raising nominal rates; inflation pushes rates upward.

Monetary policy effect on loanable funds

Central bank actions that change the money supply shift the supply of loanable funds and influence interest rates.

Budget deficit and crowding-out effect

A larger government demand for funds can crowd out private demand for funds, raising or altering interest rates.

Forecasting Net Demand (ND)

ND = DA − SA; the net demand for loanable funds used to forecast future interest rates.

Net Demand (ND) = DA − SA

Net demand equals total demand minus total supply of loanable funds across all sectors.

Framework for forecasting interest rates (Exhibit 2.14)

A structured approach using future expectations of demand and supply of loanable funds to predict interest rates.

Shift vs. movement along the demand curve

Taxes or policy changes can shift the demand curve for loanable funds to the right or left, while other changes move along the curve.

Inverse relationship: interest rate and household loanable funds demand

As the interest rate falls, the quantity of loanable funds demanded by households tends to rise.

Fed’s role in loanable funds

Federal Reserve actions affect the supply of loanable funds through monetary policy, influencing interest rates.

Exhibit 2.1 relationship (household demand)

Demonstrates how factors like taxes can shift the household demand curve for loanable funds.

Equilibrium graph concept (i)

Graphical representation where DA and SA intersect at the equilibrium interest rate i.

Exhibit 2.14 ND forecasting framework

A step-by-step approach to forecast interest rates by analyzing projected net demand and its components.