Question

For a usury law to be effective, it must set the interest rate ceiling (LO4) a) above the equilibrium rate of interest b) below the equilibrium rate of interest c) at exactly the equilibrium rate of interest

Short answer

For a usury law to be effective, it must set the interest rate ceiling below the equilibrium rate of interest. This effectively caps interest rates but may result in unintended consequences such as loan shortages, credit rationing, or increased illegal lending practices.

Step-by-step solution

Option a: Above the equilibrium rate of interest

If the interest rate ceiling is set above the equilibrium rate of interest, the demand and supply of loans will naturally reach an equilibrium at a rate below the ceiling. In this situation, the usury law will have no substantial impact on the market, as the interest rates would still be determined by the market forces. Therefore, this option would not lead to an effective usury law.

Option b: Below the equilibrium rate of interest

If the interest rate ceiling is set below the equilibrium rate of interest, the demand for loans will exceed the supply, as borrowers would want to take advantage of the artificially lower interest rates. On the other hand, lenders will be less inclined to provide loans at lower rates, as they might not be adequately compensated for their risk. This situation results in a shortage of available loans in the market and can lead to credit rationing or an increase in illegal lending practices. However, since the interest rate is effectively capped, this option would lead to an effective usury law with potential unintended consequences.

Option c: At exactly the equilibrium rate of interest

If the interest rate ceiling is set exactly at the equilibrium rate of interest, the demand and supply of loans will be in balance. However, this option doesn't provide any buffer for when the market dynamics change, leading to a shift in the equilibrium interest rate. In such cases, the usury law would either become ineffective (if the new equilibrium rate is below the ceiling) or lead to consequences similar to option b (if the new equilibrium rate is above the ceiling). Therefore, this option might not lead to an effective usury law in the long run. Based on the analysis of each option, we can now answer the exercise: Setting the interest rate ceiling of a usury law for it to be effective should be: a) above the equilibrium rate of interest (ineffective) b) below the equilibrium rate of interest (effective but with potential unintended consequences) c) at exactly the equilibrium rate of interest (not consistently effective in the long run)