146 ❯ Step 4. Review the Knowledge You Need to Score High
How Is the Money Market Different from the Market for Loanable Funds?
Understanding the difference between the money market and the loanable funds market
can be tough, so we’ll take it in two and a half parts. I’m sure the first is much more
helpful, the second much more esoteric, and the half is going to earn you the graphing
points.- Breadth of scope.
The supply of loanable funds, which varies directly with the interest rate, comes from
saving. The supply of money is more inclusive than just saving; it includes currency
and checking deposits. A $100 bill in your wallet would fall into the money supply
curve, but not into the supply of loanable funds. The demand for loanable funds comes
from investment demand. The demand for money includes the money used for invest-
ment, but also for consumption (transaction demand) and for holding as an asset (asset
demand). So basically the money market, both on the supply and the demand side, is
broader, and more inclusive, than the market for loanable funds. The price (aka the
interest rate) appears to be the same in both markets, and is the result of... - Different philosophies.
We don’t want to delve too much into the Keynesian versus Classical philosophical
debates because they are quite unlikely to appear on your AP Macroeconomics exam.
It can seem a little confusing to show the interest rate as the “price” in both the market
for loanable funds and the market for money. The reason that both markets are pre-
sented here, and in your textbook, is that they represent fundamental differences in
macroeconomic philosophies.
• Classical economists believe that the price level is flexible and long-run GDP adjusts
to the natural rate of employment. For any level of GDP, the interest rate adjusts
to balance the supply and demand for loanable funds and the price level adjusts to
keep the money market in equilibrium.
• Keynesian economists believe that the price level is sticky. For any price level, the
interest rate adjusts to balance the supply and demand for money, and this interest
rate influences aggregate demand and thus the short-run level of GDP.
• Bottom line here: The two different ways of looking at the interest rate are the result
of two different ways of looking at the overall economy and the difference in the
long-run (Classical) and short-run (Keynesian) views of the economy.
... and^1 ⁄ 2. Graphing.
While it appears that the same interest rate is graphed on the vertical axis of both the
loanable funds and money market graphs, they are not in fact the same. It is correct
to label the vertical axis of the money market with a nominal interest rate and the
vertical axis of the loanable funds market with the real interest rate. Changes in the
money market can be viewed as short-term changes, and therefore the role of expected
inflation is negligible. For long-term decisions like investment and saving, the price of
investment, or return on saving, does depend upon expected inflation, and so it makes
sense to focus on the real rate of interest when making long-term plans. Here’s a way
to keep it straight: “Loanable funds are REAL-ly fun.”
• When asked to draw the money market, the best way to ensure that you receive the
graphing point is to label the vertical axis in the money market as the “Nominal
interest rate” or “n.i.r.”
TIP“This is an
important
question. Know
the difference”.
—AP Teacher