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Eco558 Notes Chap 5
Eco558 Notes Chap 5
Eco558 Notes Chap 5
Theory
Classical Interest Rate Theory
Interest rates is determined by supply
of and demand for loanable funds (LF).
What is loanable funds market?
Where do supply of and demand for
loanable funds come from?
Loanable Funds Market
Refers to the market where savers and borrowers exchange funds (QLF) at
the rate of interest (r%).
Savers are households, firms and government sectors who buy bonds,
thus creating supply the LF.
This is called saving (S) = supply of LF
So, the supply of LF (savings) is the demand for bonds.
Borrowers are households, firms and government sectors who sell
bonds, thus creating demand for LF.
Investment and budget deficit (G-T) = demand for LF
So, the demand for LF (I + G-T) is the supply of bonds.
Equilibrium interest rate is the rate at which Qty of LF demanded = Qty
of LF supplied.
the point of intersection between supply and demand curves
Supply of LF (Savings)
Qty of savings is positively related to the
rate of interest —the higher the rate of
interest, the more will be saved.
Interest earned on savings is a reward for
delaying consumption in favor of future
consumption
At higher interest rates people will be more
willing to forgo present consumption, so
saving increases
Demand for LF
Assume that government borrowing is zero
(balanced budget), demand for LF comes from
Investment
◦ Investors borrow to make investment.
◦ The cost of borrowing is the interest charges.
◦ The lower the rate of interest, the more
entrepreneurs will borrow and invest
◦ Therefore, investment depends negatively on
the rate of interest.
Equilibrium Rate of Interest
Happens when quantity
of total savings = quantity
of total investment
Represented by the
intersection between the
supply and demand
curves for loanable funds.
The equilibrium rate of
interest is r
Changes in the Equilibrium Rate of Interest
Happens due to shifts in supply and/or
demand
Any shift in the supply or demand for
loanable funds will cause market forces to
drive the rate of interest back into
equilibrium at a different level
This flexibility in the rate of interest will
ensure that the amount of savings is always
equal to investment and total income will
always equal total spending
Increased saving calls forth increased investment
An autonomous increase in S
shifts the curve to the right
At the old equilibrium, there is
of interest to fall.
Interest rate will fall until the