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So, you have a lot of money and want to save all of it for a rainy day by lending it to the bank. On top of this, the bank rewards you with a little extra on your money. This little extra you're rewarded with is the interest rate. Surely, if this interest rate increases, you'll be encouraged to save even more money.
All this occurs in the loanable funds market, where the interest rate is the price for supplying money. Essentially, the higher the interest rate, the more money you will supply. Okay, you have supplied the money and want to know what happens within the year that follows - this means you're interested in the short-run interest rate. Read on to find out what happens!
In terms of interest rate, the short-run refers to a year or below. So, the short-run interest rate is the interest rate on your savings that matures within a year.
The short-run interest rate is the interest rate on savings that matures within a year.
Good, we have got the definition of short-run interest rate. Now, let's explain what it's all about so you can make more sense of this definition.
While there are numerous financial markets where all sorts of financial assets exist, economists simplify things in the loanable funds market. In the loanable funds market, some borrow money and those who lend money. These two represent the demand and supply forces in the loanable funds market.
In the loanable funds market, borrowers are matched with lenders. The borrowers are those who want to spend money on investments, and the lenders are those who want to save money.
The interest rate represents the price in the loanable funds market, denoted by r. Transactions in the loanable funds market take time to be completed (and for lenders to receive their payment). The short-run is concerned with the maximum period of one year within which lenders can receive their payment.
Remember the definition for short-run interest rate - the interest rate on savings that matures within a year.
Figure 1 visualizes how money lenders and borrowers interact in the loanable funds market. The interest rate is plotted on the vertical axis. In contrast, the quantity of loanable funds is plotted on the horizontal axis.
Figure 1. Demand for loanable funds, StudySmarter Originals
In figure 1 above, it can be observed that the interest rate has an inverse relationship with the quantity demanded of loanable funds. As the interest rate goes down, the quantity demanded of loanable funds increases.
The demand for loanable funds follows the law of demand. This can be seen as the curve slopes downward because the borrowers borrow less as the interest rate increases.
So, what happens in the short run due to changes in the interest rate? Let's look at the example below.
In an economy, the interest rate on lending money is reduced.The lenders see this and decide it is not worth it to lend out as much money. So, they reduce their lending and spend on investments instead. This spending increases the GDP of the economy since investment spending is one of the factors of the GDP.
Consumer spending also increases as a result, and since some fraction of disposable income is saved with each transaction, savings also increase. Eventually, the savings increases to match the investment spending, and the economy reaches equilibrium.
From the example, we can tell that when the interest rate reduces in the short run, it reduces lending, increases investment spending, increases consumer spending, and increases savings until the economy reaches a new equilibrium.
When the interest rate reduces in the short run, it reduces lending, increases investment spending, increases consumer spending, and increases savings until the economy reaches a new equilibrium.
Let's look at what happens when the short-run interest rate increases or decreases. We will do this with the help of graphs.
Figure 2. Decrease in short-run interest rate, StudySmarter Originals
The left side of Figure 2 shows the money market. It can be seen that the reduction in the interest rate (from r1 to r2) begins in the money market. This results in an increase in the quantity of money demanded (from M1 to M2) and a resulting increase in money supply (from MS1 to MS2). This results in an increase in real GDP and an increase in the supply of loanable funds (from S1 to S2).
The left side overlaps with the right side because as the interest rate decrease has caused an increase in money supply, lenders are discouraged from lending due to the reduced interest rate. Therefore, they increase investment spending instead. From this, consumer spending increases, and this increase means increased savings. The increase in savings means an increase in money supply (on the right side of Figure 2, S1 to S2); hence, the new equilibrium (E2)
Lenders are incentivized to lend more if the interest rate increases in the short term. This leads to reductions in investment spending, consumer spending, and savings. The reduction in savings means supply decreases in the loanable funds market. Therefore, the equilibrium shifts to the left.
Remember this: when the interest rate reduces in the short run, it reduces lending, increases investment spending, increases consumer spending, and increases savings until the economy reaches a new equilibrium. The opposite of all this occurs when the short-run interest rate increases.
In the long run, the increased money supply (and decreased short-term interest rate, but it does not stop there) causes increases in wages and other nominal prices, which causes an increase in money demand. Look at Figure 3.
Figure 3. Long-run interest rate, StudySmarter Originals
Looking on the left side of Figure 3, the increased money supply causes increases in wages and other nominal prices in the long run, which cause an increase in money demand. The money demand curve shifts (from MD1 to MD2), and the new equilibrium in the money market has the interest rate of r1 (interest rate increased back to r1 from r2).
In the short run, only the money supply curve shifted. Still, in the long run, the money demand curve shifted, which returned the equilibrium interest rate to its original value.
On the right side, since the short-run effect on the interest rate has been undone in the long run in the money market, the supply in the loanable funds market responds by shifting back to its original position. This means that when the money supply changes, the interest rate remains unchanged in the long run.
So, focusing on the loanable funds market, the equilibrium interest rate is the rate at which the supply and demand for loanable funds are equal when the economy has reached its potential output.
In the long run, the equilibrium interest rate is the rate at which the supply and demand for loanable funds are equal when the economy has reached its potential output.
Businesses decide to take loans based on the rate of return on their projects and the current interest rate. A business will only take a loan if the rate of return is equal to or more than the interest rate. Look at the following example.
A business will only take a loan if the rate of return is equal to or more than the interest rate.
Consider this example below:
A business costs $20,000 and has a revenue of $25,000. The interest rate in the economy is 5%. Help the business decide whether to take a loan.
Therefore, for this business, the rate of return is:
Since the rate of return of 25% is more than the interest rate of 5%, the business will take a loan.
Yay! You made it to the end of this article! You should read our article on the Loanable Funds Market to make things even clearer!
The short-run interest rate is the interest rate on savings that matures within a year.
The supply of money in the money market.
In the long run, the increased money supply (and decreased short-term interest rate, but it does not stop there) causes increases in wages and other nominal prices which causes an increase in money demand.
An increase in money supply in the short run decreases the interest rate, reduces lending, increases investment spending, increases consumer spending, and increases savings, until the economy reaches a new equilibrium.
Short-run interest rate is affected by an increase in money supply, however, long-run interest rate is not.
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