Question

Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged.

Short answer

The increase in the supply of loanable funds and the decrease in the demand for loanable funds result in a lower real interest rate and the same equilibrium quantity of loanable funds.

Step-by-step solution

Identify the Axes

Identify the axes for the graph. The x-axis will represent the quantity of loanable funds, and the y-axis will represent the real interest rate.

Draw the Initial Supply and Demand Curves

Draw the initial supply and demand curves for loanable funds. Label them as S1 and D1 respectively. The point where they intersect is the initial equilibrium point (E1), representing the initial real interest rate (r1) and quantity of loanable funds (Q1).

Shift the Supply Curve

Illustrate an increase in the supply of loanable funds by shifting the supply curve to the right, from S1 to S2. This shift reflects that more loanable funds are available at every interest rate.

Shift the Demand Curve

Illustrate a decrease in the demand for loanable funds by shifting the demand curve to the left, from D1 to D2. This shift reflects that less loanable funds are demanded at every interest rate.

Identify the New Equilibrium

The new supply curve (S2) and the new demand curve (D2) will intersect at a new equilibrium point (E2). This new point will show a lower real interest rate (r2) but the same equilibrium quantity of loanable funds (Q1). Label this on the graph.

Add Consistency Checks

Check that the new equilibrium quantity of loanable funds (Q1) is the same as the initial equilibrium quantity and that the new real interest rate (r2) is less than the initial real interest rate (r1).

Key concepts

Supply and Demand

In the loanable funds market, the concepts of supply and demand are crucial. Loanable funds represent all the money available for borrowing in the economy. The **supply** of loanable funds comes from people saving their money. People deposit money into banks, which then become available for others to borrow. The more people save, the more the supply increases.
The **demand** for loanable funds comes from borrowers, such as individuals seeking mortgages or companies wanting to invest in new projects. The higher the need for borrowing, the higher the demand for these funds.
When we discuss changes in the supply and demand of loanable funds, we use supply and demand curves. These curves help visualize how changes in the economy affect interest rates and borrowed money. The intersection of the supply and demand curves determines the equilibrium point, where the quantity of loanable funds supplied matches the quantity demanded.

Real Interest Rate

The **real interest rate** is the cost of borrowing adjusted for inflation. It represents the actual purchasing power that borrowers pay and lenders receive. For example, if the nominal interest rate (the stated rate) is 5% and inflation is 2%, the real interest rate is 3%.
Real interest rates are important because they reflect the true cost of borrowing and the true return on savings. In the loanable funds market, this rate is determined by the equilibrium where supply meets demand.
The exercise asks to illustrate how the real interest rate can be lowered by changes in supply and demand. An **increase in the supply** of loanable funds means more money is available for borrowing, putting downward pressure on interest rates. Conversely, a **decrease in the demand** for loanable funds means fewer people or companies are looking to borrow, which also lowers interest rates. Both these effects lead to a lower real interest rate while keeping the equilibrium quantity of loanable funds the same.

Equilibrium Quantity

The **equilibrium quantity** in the loanable funds market is the quantity at which the amount of funds supplied equals the amount of funds demanded. This occurs at the equilibrium interest rate where the supply and demand curves intersect.
In the exercise, we see that even though the supply increases and the demand decreases, the equilibrium quantity remains unchanged. This happens because the shifts in supply and demand perfectly offset each other, leading to a new equilibrium with a lower interest rate but the same quantity of loanable funds.
The stability in the equilibrium quantity despite changes in supply and demand highlights an important feature of the market – its ability to self-correct and find a new balance. This concept helps us understand how monetary policy and economic conditions can affect lending and borrowing behaviors without drastically altering the amount of money traded.