Questions: Interest Rates and the Loanable Funds Market

Question 1

The government increases its budget deficit sharply. In the loanable funds model, the most direct effect is:

• A. An increase in the supply of loanable funds, lowering the real interest rate
• B. A decrease in the supply of loanable funds, raising the real interest rate and crowding out private investment
• C. An increase in the demand for loanable funds, lowering the real interest rate
• D. No effect, because the central bank controls interest rates, not the government

Answer: (B)

Government dissaving (a deficit) reduces national saving — the government is borrowing from the pool of loanable funds rather than contributing to it. This shifts the supply curve left, raising the equilibrium real interest rate. Higher rates make private investment more expensive, reducing it — the crowding-out effect. The central bank sets the nominal policy rate, but the loanable funds model focuses on the real rate determined by saving and investment flows.

Question 2

If the nominal interest rate is 7% and expected inflation is 4%, economic decisions about borrowing and lending should be based on a 7% interest rate.

• T. True
• F. False

Answer: False

The relevant rate for real economic decisions is the real interest rate — approximately nominal rate minus expected inflation, so about 3% here. Borrowers repay in future dollars that are worth less due to inflation, so the real burden of debt is lower than the nominal rate suggests. Lenders likewise earn less in purchasing-power terms. Basing decisions on the nominal rate would overstate the true cost of borrowing and the true return to saving.

Question 3

In the loanable funds model, saving and investment must be equal in equilibrium. What mechanism brings them into equality when they start out unequal?

Model answer: The real interest rate adjusts. If desired saving exceeds desired investment, excess supply pushes the rate down, discouraging saving and encouraging more investment until they equate. The reverse happens when investment demand exceeds saving.

The interest rate functions as the price in the market for loanable funds — it coordinates the decisions of savers and investors. Unlike the ex-post accounting identity (S = I by definition in a closed economy), the model describes the equilibrating process: how mismatches between desired saving and desired investment are resolved through price adjustment. This is the classic supply-and-demand mechanism applied to capital.