interactive activity
Appendix
15
Reconciling the
Two Models of
the Interest Rate
1. Using a figure similar to Figure 15A-1, explain how the money market and the
loanable funds market react to a reduction in the money supply in the short run.
1. In the accompanying diagram, both the money market and the loanable funds
market are initially in equilibrium at the same rate of interest, r1. A decrease
in the money supply shifts the money supply curve leftward, to MS2, and the
equilibrium interest rate rises to r2. The increase in the interest rate leads to a
decrease in real GDP, which generates a decrease in savings through the multi-
plier process. This decrease in savings shifts the supply curve for loanable funds
leftward, to S2. Consequently, the equilibrium interest rate in the loanable funds
market rises. The new equilibrium interest rate in the loanable funds market
equals the rate in the money market because savings fall by exactly enough to
match the fall in investment spending.
MS1
MS2
Interest
rate, r
Quantity
of money
E2
S2
S1
Interest
rate, r
Quantity of
loanable funds
E2
Solution
WORK IT OUT Interactive step-by-step help with solving this
problem can be found online.
2. Contrast the short-run effects of an increase in the money supply on the
interest rate to the long-run effects of an increase in the money supply on
the interest rate. Which market determines the interest rate in the short
run? Which market does so in the long run? What are the implications of
S-216 15 APPENDIX Reconciling the two Models of the inteRest Rate