Nominal Interest Rates, Real Interest Rates, and the Loanable Funds Market

Nominal and Real Interest Rates

  • Nominal Interest Rate: The stated interest rate not adjusted for inflation.

  • Real Interest Rate: The interest rate adjusted for inflation, calculated as the nominal interest rate minus inflation:   Real Interest Rate=Nominal Interest Rate−Inflation\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation}

  • Economic Meaning and Significance:

    • It represents what the interest rate looks like when accounting for inflation.

    • It reflects the true cost of borrowing for debtors.

    • It reflects the true return of saving for creditors.

Demand for Loanable Funds

  • Definition: The funds that firms and, to some extent, the government want to borrow.

  • Slope of the Demand Curve: The demand curve for loanable funds is downward sloping.

    • Mechanism: As the interest rate falls, the cost of borrowing becomes lower. Consequently, firms become more willing to borrow, leading to an increase in the quantity demanded of loanable funds.

  • Firm Borrowing Decision Rule: Firms will borrow as long as the rate of return from new projects exceeds the interest rate:   Rate of Return from New Projects>Interest Rate\text{Rate of Return from New Projects} > \text{Interest Rate}

Supply of Loanable and Vulnerable Funds

  • Definition: The funds that come from savings that are available to lend (referred to as the supply of vulnerable funds/loanable funds).

  • Slope of the Supply Curve: The supply curve for vulnerable/loanable funds is upward sloping.

    • Mechanism: As the interest rate rises, people become more willing to save because the incentive to save increases, leading to an increase in the quantity supplied of loanable funds.

Market Shifts and Determinants

  • Determinants of the Supply of Loanable (Vulnerable) Funds:

    • Increase in Disposable Income: Causes the supply of vulnerable funds to increase.

    • Increase in Wealth: Causes the supply of vulnerable funds to decrease, because people save less.

    • Increase in Expected Future Income: Causes the supply of loanable funds to decrease, because people save less.

    • Increase in Default Risk: Causes the supply of loanable funds to decrease.

  • Determinants of the Demand for Loanable Funds:

    • Increase in Expected Future Profitability of a Project: Causes the demand for loanable funds to increase, as firms want to borrow more to invest.

    • Increase in Default Risk: Causes the demand for loanable funds to decrease.

Questions & Discussion

  • Question: Wealth in the loanable funds market belongs to which side?

  • Response: People / Supply side.