Working with the Loanable Funds Market Draw the market for loanable funds and graph the supply and demand for each of the following scenarios. Draw the shift occurring (Supply or Demand) and explain what happens to the equilibrium interest rate in each case because of the shift: 1. A breakthrough in medical technology results in many hospitals wanting to buy new equipment. 2. The government budget deficit is reduced by . 3. Foreign investors buy residential property in the United States. 4. People around the world are worried about financial stability in their countries and choose to move their wealth to U.S. financial markets.
The Correct Answer and Explanation is:
The loanable funds market shows the relationship between the supply of savings (loanable funds) and the demand for borrowing (investment) at different interest rates. The supply curve (S) slopes upward because higher interest rates encourage more saving, while the demand curve (D) slopes downward because lower interest rates make borrowing more attractive.
Scenario 1: Breakthrough in medical technology leads to hospitals wanting to buy new equipment
In this case, hospitals’ demand for loanable funds increases due to the need to borrow money to finance the purchase of new medical equipment. As a result, the demand curve (D) shifts to the right (D1). The increased demand for loanable funds pushes the equilibrium interest rate higher.
- Shift: Rightward shift of the demand curve.
- Outcome: The equilibrium interest rate rises, as demand for funds exceeds the available supply at the previous rate.
Scenario 2: Government budget deficit is reduced
When the government reduces its budget deficit, it borrows less from the loanable funds market. This decreases the demand for loanable funds, shifting the demand curve (D) to the left (D2). With less government borrowing, the supply of funds exceeds demand at the original interest rate, which leads to a decrease in the equilibrium interest rate.
- Shift: Leftward shift of the demand curve.
- Outcome: The equilibrium interest rate falls, as reduced government borrowing decreases the demand for funds.
Scenario 3: Foreign investors buy residential property in the United States
Foreign investors seeking to purchase property in the U.S. represent an increase in demand for loanable funds in the U.S. financial markets. This raises the demand for dollars and borrowing in the U.S. economy, shifting the demand curve (D) to the right (D3). This increased demand for funds raises the equilibrium interest rate.
- Shift: Rightward shift of the demand curve.
- Outcome: The equilibrium interest rate increases due to foreign investment requiring more funds.
Scenario 4: People move wealth to U.S. financial markets due to global financial instability
When people are worried about financial stability in their own countries, they tend to move their wealth to safer financial markets, such as the U.S. This increases the supply of loanable funds in the U.S., shifting the supply curve (S) to the right (S1). With more funds available for lending, the equilibrium interest rate decreases.
- Shift: Rightward shift of the supply curve.
- Outcome: The equilibrium interest rate falls, as the supply of funds exceeds demand at the previous rate.
In summary, shifts in demand and supply for loanable funds affect the equilibrium interest rate, with increased demand pushing rates higher and increased supply pushing rates lower.
