changes in savings. Panel (a) represents the liquidity preference model of the interest
rate.MS 1 andMD 1 are the initial supply and demand curves for money. According to
the liquidity preference model, the equilibrium interest rate in the economy is the rate
at which the quantity of money supplied is equal to the quantity of money demanded
in the money market. Panel (b) represents the loanable funds model of the interest rate.
S 1 is the initial supply curve and Dis the demand curve for loanable funds. According
to the loanable funds model, the equilibrium interest rate in the economy is the rate at
which the quantity of loanable funds supplied is equal to the quantity of loanable
funds demanded in the market for loanable funds.
In Figure 29.7 both the money market and the market for loanable funds are initially
in equilibrium at E 1 with the same interest rate, r 1. You might think that this would hap-
pen only by accident, but in fact it will always be true. To see why, let’s look at what hap-
pens when the Fed increases the money supply from M 1 toM 2. This pushes the money
supply curve rightward to MS 2 , causing the equilibrium interest rate in the market for
money to fall to r 2 , and the economy moves to a short-run equilibrium at E 2. What hap-
pens in panel (b), in the market for loanable funds? In the short run, the fall in the inter-
est rate due to the increase in the money supply leads to a rise in real GDP, which
generates a rise in savings through the multiplier process. This rise in savings shifts the
supply curve for loanable funds rightward, from S 1 toS 2 , moving the equilibrium in the
loanable funds market from E 1 toE 2 and also reducing the equilibrium interest rate in
the loanable funds market. And we know that savings rise by exactly enough to match the
rise in investment spending. This tells us that the equilibrium rate in the loanable funds
market falls to r 2 , the same as the new equilibrium interest rate in the money market.
In the short run, then, the supply and demand for money determine the interest rate,
and the loanable funds market follows the lead of the money market. When a change in
the supply of money leads to a change in the interest rate, the resulting change in real
GDP causes the supply of loanable funds to change as well. As a result, the equilibrium
interest rate in the loanable funds market is the same as the equilibrium interest rate in
the money market.
Notice our use of the phrase “in the short run.” Changes in aggregate demand affect
aggregate output only in the short run. In the long run, aggregate output is equal to
potential output. So our story about how a fall in the interest rate leads to a rise in ag-
gregate output, which leads to a rise in savings, applies only to the short run. In the
long run, as we’ll see next, the determination of the interest rate is quite different be-
cause the roles of the two markets are reversed. In the long run, the loanable funds mar-
ket determines the equilibrium interest rate, and it is the market for money that
follows the lead of the loanable funds market.
The Interest Rate in the Long Run
In the short run an increase in the money supply leads to a fall in the interest rate, and
a decrease in the money supply leads to a rise in the interest rate. In the long run, how-
ever, changes in the money supply don’t affect the interest rate.
Figure 29.8 on the next page shows why. As in Figure 29.7, panel (a) shows the liq-
uidity preference model of the interest rate and panel (b) shows the supply and demand
for loanable funds. We assume that in both panels the economy is initially at E 1 , in
long -run macroeconomic equilibrium at potential output with the money supply
equal to M 1. The demand curve for loanable funds is D,and the initial supply curve for
loanable funds is S 1. The initial equilibrium interest rate in both markets is r 1.
Now suppose the money supply rises from M 1 toM 2. As we saw in Figure 29.7, this ini-
tially reduces the interest rate to r 2. However, in the long run the aggregate price level will
rise by the same proportion as the increase in the money supply (due to the neutrality of
money,a topic presented in detail in the next section). A rise in the aggregate price level in-
creases money demand in the same proportion. So in the long run the money demand
curve shifts out to MD 2 , and the equilibrium interest rate rises back to its original level, r 1.
Panel (b) of Figure 29.8 shows what happens in the market for loanable funds. We saw
earlier that an increase in the money supply leads to a short -run rise in real GDP and that
module 29 The Market for Loanable Funds 285
Section 5 The Financial Sector