AP_Krugman_Textbook

286 section 5 The Financial Sector

this shifts the supply of loanable funds rightward from S 1 toS 2. In the long run, however,

real GDP falls back to its original level as wages and other nominal prices rise. As a result,

the supply of loanable funds, S,which initially shifted from S 1 toS 2 , shifts back to S 1.

In the long run, then, changes in the money supply do not affect the interest rate. So

what determines the interest rate in the long run—that is, what determines r 1 in Figure

29.8? The answer is the supply and demand for loanable funds. More specifically, in the

long run the equilibrium interest rate is the rate that matches the supply of loanable

funds with the demand for loanable funds when real GDP equals potential output.

Quantity

of money

r 1

r 2

Interest

rate, r

E 2

E 3

E 1

MD 1

MD 2

MS 1 MS 2

2.... which raises
the interest rate back
to its original level...

1. In the long run, the rise in the price level
   shifts the money demand curve to the right,...

Quantityof

loanable funds

r 1

r 2

Interest

rate, r

E 1

E 2

S 2

D

S 1

(a) The Liquidity Preference Model of the Interest Rate (b) The Loanable Funds Model of the Interest Rate

M 1 M 2 Q 1 Q 2

3.... reducing real
GDP and the supply
of loanable funds
until aggregate
output equals
potential output.

figure 29.8 The Long -run Determination of the Interest Rate

Panel (a) shows the liquidity preference model long-run adjustment to

an increase in the money supply from M–– 1 toM–– 2 ; panel (b) shows

the corresponding long-run adjustment in the loanable funds market.

As we discussed in Figure 29.7, the increase in the money supply re-

duces the interest rate from r 1 tor 2 , increases real GDP, and increases

savings in the short run. This is shown in panel (a) and panel (b) as

the movement from E 1 toE 2. In the long run, however, the increase in

the money supply raises wages and other nominal prices; this shifts

the money demand curve in panel (a) from MD 1 toMD 2 , leading to an

increase in the interest rate from r 1 tor 2 as the economy moves from

E 2 toE 3. The rise in the interest rate causes a fall in real GDP and a

fall in savings, shifting the loanable funds supply curve back to S 1

fromS 2 and moving the loanable funds market from E 2 back to E 1. In

the long run, the equilibrium interest rate is the rate that matches

the supply and demand for loanable funds when real GDP equals

potential output.

Module 29 AP Review

Check Your Understanding

1. Use a diagram of the loanable funds market to illustrate the
   effect of the following events on the equilibrium interest rate
   and quantity of loanable funds.
   a. An economy is opened to international movements of
   capital, and a capital inflow occurs.
   b. Retired people generally save less than working people at any
   interest rate. The proportion of retired people in the
   population goes up.
   2. Explain what is wrong with the following statement: “Savings and
   investment spending may not be equal in the economy as a whole
   in equilibrium because when the interest rate rises, households
   will want to save more money than businesses will want to invest.”
   3. Suppose that expected inflation rises from 3% to 6%.
   a. How will the real interest rate be affected by this change?
   b. How will the nominal interest rate be affected by this change?
   c. What will happen to the equilibrium quantity of loanable
   funds?

Solutions appear at the back of the book.