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4) In Freedonia, there is a supply and demand for loanable funds. Suddenly, consumer confidence decreases....

4) In Freedonia, there is a supply and demand for loanable funds. Suddenly, consumer confidence decreases. This decrease causes consumers to spend less of their income on goods and services. At the same time, firms’ demand for loanable funds increases due to expectations of the future. What happens to interest rates, the quantity of loanable funds, Investment, and GDP? Use graphs to explain when possible.

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Answer #1

Loanable fund theory uses demand and supply for fund to decide equilibrium interest rate. Sudden, decrease in consumer confidence would reduce demand for loanable fund. Likewise rise in demand for loanable fund due to future expectation would lead to shift in demand curve to right.

If we assume that demand from firms tend to be stronger than Demand curve shifts to right. Following is diagram:

  • In above diagram, demand curve shift to right thereby leading to rise in Real Interest Rate and GDP.
  • Rise in future expected profits would incentivise business firm to make more investments and demand for more investment pushes up interest rate and GDP of country.  
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