AP_Krugman_Textbook

Figure 29.5 shows the effects of an increase in the supply of loanable funds. Dis 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 RatesAnything 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 rateand 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

figure 29.5

An Increase in the Supply of

Loanable Funds

If the quantity of funds supplied by lenders

rises at any given interest rate, the supply of

loanable funds shifts rightward from S 1 toS 2.

As a result, the equilibrium interest rate falls

fromr 1 tor 2.

Interest

rate, r

D

S 1

S 2

r 1

r 2

Quantity of

loanable funds

... leads to
a fall in the
equilibrium
interest rate.

An increase

in the supply

of loanable

funds...