Question

1. In the loanable funds market, what will change to eliminate a shortage of loanable funds? and explain the entire process of how the shortage will be eliminated?

2. Why is the nominal interest rate the opportunity cost of holding money?

Answer 1

Shortage implies that quantity demanded of loanable funds OS greater than quantity supplied of loanable funds. This happens when interest rate is greater than equilibrium interest rate. So to get to the equilibrium where quantity demanded of loanable funds is equal to quantity supplied of loanable funds. When we increase interest rate quantity deemed decreases and quantity supplied increases. Interest rate keeps on increasing until equilibrium is reached.

Nominal interest rate is the opportunity cost of holding money because if the money is deposited, it can earn nominal interest. It is the next best alternative to holding money.