Kenneth R. Szulczyk
Consequently, the real interest rate equals 5% in Figure 10 while the amount of funds in the
market is L*.
If the world’s real interest rate were 9%, then the domestic investors would invest their
funds in the international market, earning a higher interest rate in Figure 10. However,
businesses and governments would not borrow funds at this interest rate because it is too high.
Consequently, the difference between quantity supplied and quantity demanded reflects the
amount of funds leaving the country at 9% real interest rate. If this country were a closed
economy, subsequently, the market would have a surplus, and market forces would lower the
real interest rate to 5%.
Figure 10. Loanable funds in an open economy
If the world’s real interest rate were 1%, then firms and the government would borrow at
the cheap rates in Figure 10. However, the domestic investors would not lend at that rate.
Consequently, the difference between quantity demanded and quantity supply reflects the
amount of funds entering the country. If this country were closed, then the loanable funds
market would cause a shortage, and market forces would increase the real interest rate.
We assumed the country is a small open economy because this country is too little to
influence the world’s real interest rate. Many countries, such as the Netherlands and Belgium
would fall within this category. However, a large country like the United States, Germany, or
Japan would affect the world’s real interest rate.
Key Terms
bond market
demand function
supply function
equilibrium
increase in demand
decrease in demand
Fisher Effect
loanable funds