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Loanable Funds Theory

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Suppose the total demand and supply of loanable funds (in billions) are as follows:

Quantity demanded of loanable funds Interest rate (percent) Quantity supplied of loanable funds Surplus (+)
shortage (-)
85 4 72 _____
80 6 73 _____
75 8 75 _____
70 10 77 _____
65 12 79 _____
60 14 81 _____

(a) What will be the market or equilibrium interest rate? What is the equilibrium quantity of loanable funds? Complete the surplus-shortage column.
(b) Why will 4% not be the equilibrium interest rate in this market? Why not 14%?
(c) Now suppose that the government establishes a usury loan that sets the interest rate at 6%. Explain the economic effects of this usury law.

Briefly explain the loanable funds theory of interest rate determination. How would the following situations affect the equilibrium interest rate in the loanable funds market?
(a) The states agree to abolish sales taxes.
(b) The government reduces the budget deficit.
(c) Technological improvements are made to increase expected rates of return.

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Solution Summary

Loanable funds theory; equilibrium interest rate; economic effects of usury law.