Page 324 - Krugmans Economics for AP Text Book_Neat

figure 29.5

An Increase in the Supply of Interest
rate, r
Loanable Funds
If the quantity of funds supplied by lenders
S 1
rises at any given interest rate, the supply of
loanable funds shifts rightward from S 1 to S 2 . S 2
As a result, the equilibrium interest rate falls
from r 1 to r 2 .

. . . leads to r 1
a fall in the An increase
equilibrium in the supply
interest rate. r 2 of loanable
funds . . .
D

Quantity of
loanable funds

Figure 29.5 shows the effects of an increase in the supply of loanable funds. D is the
demand for loanable funds, and S 1 is the initial supply curve. The initial equilibrium
interest rate is r 1 . An increase in the supply of loanable funds means that the quantity
of funds supplied rises at any given interest rate, so the supply curve shifts rightward to
S 2 . As a result, the equilibrium interest rate falls to r 2 .
Inflation and Interest Rates Anything that shifts either the supply of loanable funds
curve or the demand for loanable funds curve changes the interest rate. Historically,
major changes in interest rates have been driven by many factors, including changes in
government policy and technological innovations that created new investment oppor-
tunities. However, arguably the most important factor affecting interest rates over
time—the reason, for example, why interest rates today are much lower than they were
in the late 1970s and early 1980s—is changing expectations about future inflation,
which shift both the supply and the demand for loanable funds.
To understand the effect of expected inflation on interest rates, recall our discus-
sion in Module 14 of the way inflation creates winners and losers—for example, the
way that high U.S. inflation in the 1970s and 1980s reduced the real value of home-
owners’ mortgages, which was good for the homeowners but bad for the banks. We
know that economists capture the effect of inflation on borrowers and lenders by dis-
tinguishing between the nominal interest rate and the real interest rate, where the distinc-
tion is as follows:

Real interest rate = Nominal interest rate − Inflation rate

The true cost of borrowing is the real interest rate, not the nominal interest rate. To
see why, suppose a firm borrows $10,000 for one year at a 10% nominal interest rate.
At the end of the year, it must repay $11,000—the amount borrowed plus the interest.
But suppose that over the course of the year the average level of prices increases by
10%, so that the real interest rate is zero. Then the $11,000 repayment has the same
purchasing power as the original $10,000 loan. In effect, the borrower has received a
zero -interest loan.
Similarly, the true payoff to lending is the real interest rate, not the nominal rate.
Suppose that a bank makes a $10,000 loan for one year at a 10% nominal interest rate.
At the end of the year, the bank receives an $11,000 repayment. But if the average level
282 section 5 The Financial Sector