A-21
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What Determines
Interest Rates?
1. Using the loanable funds theory, show in a graph how each of the following events
affects the supply and demand for loans and the equilibrium real interest rate:
a. A war leads the government to increase spending on the military. (Assume
taxes do not change.)
ANSWER: With constant tax revenue and increased government spending, public
saving decreases. This decrease is represented by a leftward shift in the supply of
loanable funds and causes the real interest rate to rise. As the real interest rate rises,
the quantity of loans demanded decreases (this is represented by a movement along
the original demand curve).
b. Wars in other countries lead to higher government spending in those countries.
ANSWER: As the real interest rate is pushed up in other countries (see answer to part
[a]), domestic savers have an incentive to lend their funds abroad. This will cause
capital outflows. An increase in capital outflows reduces the supply of loanable funds
domestically and drives up the domestic real interest rate. This example illustrates
that real interest rates in all countries should move in the same direction as long as
capital is allowed to move across national borders.
c. Someone invents a new kind of computer that makes firms more productive.
Many firms want to buy the computer. Higher productivity also increases people’s
confidence in the economy, so consumers see less need to save.
ANSWER: The technological advance in the form of a new kind of computer in-
creases firms’ demand for loanable funds. Graphically this can be shown as a right-
ward shift in the demand for loanable funds. At the same time, private saving
decreases in response to higher confidence in the future of the economy. This causes
a leftward shift in the supply of loanable funds. Together the changes will increase the
equilibrium real interest rate. The impact on the quantity of funds traded cannot be
predicted.
A-22 CHAPTER 4 What Determines Interest Rates?
d. The same things happen as in part (c). In addition, increased confidence in
the economy raises net capital inflows.
ANSWER: The increase in capital inflows counteracts the decrease in private do-
mestic saving. The impact on the real interest rate is less pronounced than in (c).
Tapping into foreign saving in the form of capital inflows allows the domestic real in-
terest rate to stay at its original level even if demand for loanable funds increases.
2. Suppose the real interest rate rises. Using the loanable funds theory, discuss
whether this event is likely to reflect good economic news or is a sign of trouble.
ANSWER: A rise in the real interest rate can be caused by (1) a rightward shift in the
demand for loanable funds or (2) a leftward shift in the supply of loanable funds.
Whether this increase in the real interest rate is good news depends on the events
that caused the shifts in the first place. A rightward shift in demand for loanable funds
is equal to an increase in investment. Firms will typically increase investment in re-
sponse to positive changes, such as technological advances and investor optimism
concerning the future. In this case, the increase in the real interest rate is good news.
However, a leftward shift in the supply of loanable funds is less likely to be good news.
Such a shift can be triggered by capital flight or an increase in the budget deficit (e.g.,
because of a recession), both of which are often bad news. Also, a leftward shift in
the supply of saving can be due to a decrease in private saving. This decrease in pri-
vate saving can be good or bad news.
