Loanable Funds Markets
Problem Set
1. Use the diagram of the loanable funds market to illustrate the effect of the following events on the equilibrium
interest rate and investment spending.
a. An economy is opened to international movements of capital, and a capital inflow occurs.
As capital flows into the economy, the supply of loanable funds increases.
This is illustrated by the shift of the supply curve from S1 to S2 in the
accompanying diagram. As the equilibrium moves from E1 to E2, the
equilibrium interest rate falls from r1 to r2, and the equilibrium quantity of
loanable funds increases from Q1 to Q2.
b. Retired people generally save less than working people at any interest rate. The proportion of retired people in
the population goes up.
Savings fall due to the higher proportion of retired people, and the supply
of loanable funds decreases. This is illustrated by the leftward shift of the
supply curve from S1 to S2 in the accompanying diagram. The equilibrium
moves from E1 to E2, the equilibrium interest rate rises from r1 to r2, and
the equilibrium quantity of loanable funds falls from Q1 to Q2.
2. Use the market for loanable funds shown in the Accompanying diagram to explain what happens to private savings,
private investment spending, and the rate of interest if the following events occur. Assume that there are no capital
inflows or outflows. Illustrate with a diagram.
a. The government reduces the size of its deficit to zero.
If the government reduces its deficit to zero, there will be a
decrease in the demand for loanable funds, from D1 to D2, equal
to the reduction in the size of the deficit. In the accompanying
figure, the amount Q1 – Q3 represents the amount by which the
government decreases its deficit. In response to the decrease
in demand, the interest rate falls from r1 to r2. This fall in
interest rates will increase private investment spending from Q3
to Q2 and decrease private savings from Q1 to Q2.
b. At any given interest rate, consumers decide to save more.
Assume the budget balance is zero.
If consumers decide to save more, there will be an increase in
the supply of loanable funds. In the accompanying figure, this
is represented by the rightward shift of the supply curve from
S1 to S2. The increase in the supply of loanable funds reduces
the equilibrium interest rate from r1 to r2. In response to the
lower interest rate, private investment spending will rise from
Q1 to Q2.
