Key Terms Money, Banking, and International Finance
Figure 9. Supply and demand functions explain the Fisher Effect
Bond Prices in an Open Economy
In the previous supply-demand graphs, the bond was the good for the market. However, we
could switch the analysis, where the money exchanged for the bond becomes the commodity.
Then money becomes the loanable funds. Consequently, the bond and loanable funds markets
yield identical results because we examine the same picture in a different manner. Nevertheless,
loanable funds switch the roles of supply and demand. If investors buy bonds, then they have a
demand for bonds. Investors become a source of loanable funds because they trade money for
bonds. Thus, the investors represent the supply function in the loanable funds market. If a
businesses or governments sell bonds, then they demand loanable funds. Therefore, they
represent the demand function for loanable funds. Equilibrium price in the loanable funds
market is the interest rate while the equilibrium quantity is the amount of loanable funds.
Previous supply-demand examples viewed the bond market as a closed economy. A closed
economy has no financial transactions with other countries because the country does not allow
money and goods to flow across its borders. However, we could alter the analysis to allow
international investors into the market. An open economy is a country allows goods, services,
and financial securities to flow freely in or out of a country. Consequently, the analysis uses the
loanable funds approach. Quantity represents the amount of loanable funds while the price is the
real interest rate. We use the real interest rate because investors are concerned about their
investment return after accounting for inflation. Thus, we deduct a country’s inflation rate from
the nominal interest rate, yielding the real interest rate.
If a country were a closed, small economy, the loanable funds market would be at
equilibrium. Domestic investors represent the supply of loanable funds while businesses and
governments demand them. Furthermore, we assumed the country is small because the
investors, government, and businesses cannot influence the international interest rate.