Question

157 9 Appendix A: A Model of Private Debr Supply of Loans du Puolustablo Demand for Loans - Goods WOLISZ 2002 Isqo 5 our silen Goods lent Goods held in capital Figure 7.9. Holdings of capital and loans when x > r. When the rate of return on capital exceeds r. lenders will hold a mixed portfolio of capital and loans. The total amount of loans made is equal to L and the total amount of capital is equal to L - L. Om SW 01 Istigao smigo ar stb OT Now suppose that x > r. We know that lenders can be enticed to make loans to borrowers only if the real interest rate on loans is equal to x. This means that the real interest rate will exceed r. Such a case is illustrated in Figure 7.9. Note from Figure 7.9 that at the rate of return x, borrowers want to borrow only L, but lenders want to save L* The difference is held in the form of capital a boog word o m vi bor by sth doo 9.5 Appendix Exercises 7.4. Use the graph in Figure 7.9 to answer the following questions: . Suppose the government restricts total borrowing to an amount less than L. Wha would the effect be on capital holdings? find the effect of an increase in the supply of loans on capital and the interest rate What would the effect be on the interest rate if there were no capital? we effect of a decrease in capital's rate of return on the amount borrowed an c. Find the effect of a dec the stock of capital. - nerations. Ea

Answer 1

a. If the total amount of borrowings are restricted by the government, the amount of capital holdings of the firms will decrease because capital holdings of the firm are bought using the borrowings in the loanable funds market and if these are restricted then the amount of capital holdings will decrease.

b. An increase in the supply of loans will shift the supply of loans curve rightwards and at new equilibrium point, this leads to decrease in the rate of interest and this lowers the cost of borrowing and increases demand for loans and thus increasing capital holdings of the firm. If there was no capital, then interest rate will increase back to initial level.

c. A decrease in the capital's rate of return will reduce the net profits earned by the firm and this reduction in the profits of the firm will induce the firm to borrow less amount of money and stock of capital will eventually decline with decrease in capital's rate of return.