Equilibrium Interest Rate

Definition

The equilibrium interest rate is the rate at which the demand for and supply of loanable funds in the financial market are balanced. It is the interest rate that clears the market, where the quantity of funds demanded equals the quantity of funds supplied.

5 Must Know Facts For Your Next Test

1. The equilibrium interest rate is determined by the interaction of the demand and supply of loanable funds in the financial market.
2. If the interest rate is above the equilibrium level, there will be a surplus of loanable funds, causing the interest rate to fall to the equilibrium level.
3. If the interest rate is below the equilibrium level, there will be a shortage of loanable funds, causing the interest rate to rise to the equilibrium level.
4. Factors that can shift the demand or supply of loanable funds, such as changes in economic growth, inflation, or government policies, will lead to a new equilibrium interest rate.
5. The equilibrium interest rate plays a crucial role in the allocation of resources, as it determines the cost of borrowing for investment and the return on saving.

Review Questions

• Explain how the demand and supply of loanable funds determine the equilibrium interest rate.
  • The equilibrium interest rate is determined by the intersection of the demand and supply of loanable funds in the financial market. The demand for loanable funds represents the amount that borrowers are willing and able to borrow at various interest rates, which is inversely related to the interest rate. The supply of loanable funds represents the amount that savers are willing and able to lend at various interest rates, which is positively related to the interest rate. When the quantity of funds demanded equals the quantity of funds supplied, the market clears, and the equilibrium interest rate is established.
• Describe how changes in economic conditions can affect the equilibrium interest rate.
  • Changes in economic conditions can shift the demand or supply of loanable funds, leading to a new equilibrium interest rate. For example, if economic growth increases, the demand for loanable funds may rise as businesses and individuals borrow more to finance investment and consumption. This would cause the demand curve to shift to the right, leading to a higher equilibrium interest rate. Conversely, if inflation rises, the supply of loanable funds may increase as savers are willing to lend more to maintain their purchasing power, causing the supply curve to shift to the right and the equilibrium interest rate to fall.
• Analyze the role of the equilibrium interest rate in the allocation of resources within the economy.
  • The equilibrium interest rate plays a crucial role in the allocation of resources within the economy. As the cost of borrowing, the equilibrium interest rate influences the level of investment and consumption in the economy. A higher interest rate makes borrowing more expensive, discouraging investment and slowing economic growth. Conversely, a lower interest rate makes borrowing cheaper, encouraging investment and stimulating economic activity. Additionally, the equilibrium interest rate determines the return on saving, affecting the incentive for individuals to save and the overall level of savings in the economy. The efficient allocation of resources is essential for economic growth and development, and the equilibrium interest rate is a key factor in this process.

Related terms

Loanable Funds Market: The market where savers (suppliers of loanable funds) and borrowers (demanders of loanable funds) interact to determine the equilibrium interest rate.

Demand for Loanable Funds: The amount of funds that borrowers are willing and able to borrow at various interest rates, which is inversely related to the interest rate.

Supply of Loanable Funds: The amount of funds that savers are willing and able to lend at various interest rates, which is positively related to the interest rate.