Question

The table below shows the amount of savings and borrowing in a market for loans to purchase homes, measured in millions of dollars, at various interest rates.

What is the equilibrium interest rate (blank 1)  and quantity (blank 2) in the capital financial market? 

Now, imagine that because of a shift in the perceptions of foreign investors, the supply curve shifts so that there will be $10 million less supplied at every interest rate.

Calculate the new equilibrium interest rate (blank 3) and quantity (blank 4). 

Answer 1

In the capital financial market, savers are represented by the supply curve, and the demand curve represents borrowers. The intersection of the demand and supply curve determines the equilibrium interest rate and quantity at which demand for funds is equal to the supply of funds.

In the referred table, the equilibrium interest rate is \(7 \%\) at which quantity of borrowing \((Q d)\) is equal to the quantity of lending (Qs), that is, \$140million.

With \(\$ 10\) million less supplied at every interest rate, it is found that the equilibrium interest rate is \(8 \%\) because the quantity of borrowing 135 is equal to the quantity of lending \(145-10=135 .\)

Considering the referred table, after reduction of \(\$ 10\) million supply at every interest rate, at \(7 \%\) interest rate, quantity demanded is \(\$ 140\) million, which is not equal to quantity supplied is \(\$ 140-\$ 10=\$ 130\) million. In contrast, at \(8 \%\) interest rate, quantity demanded \(\$ 135\) is equal to quantity supplied \(\$ 145-\$ 10=\$ 135\) million.

The interest rate has risen from \(7 \%\) to \(8 \%\) because after reduction of \(\$ 10\) million supply at every interest rate; there is the fewer amount available for supply, whereas quantity demanded is same as before.

After reduction of \(\$ 10\) million supply at every interest rate, at \(7 \%\) interest rate, quantity demanded (Qd) \(\$ 140\) million exceed quantity supplied (Qs) \(\$ 140-\$ 10=\$ 130\) million and to meet extra demand in the economy, the supplier will increase its supply. According to the law of supply, suppliers will supply more at a higher price. Thus, supplier will supply \(\$ 145-\$ 10=\$ 135\) million at higher interest rate than \(7 \%,\) which is \(8 \% .\)

Therefore, the market operates at \(8 \%\) interest rate, which is the new equilibrium interest rate, and the new equilibrium quantity is \(\$ 135\) million to meet the extra demand. Hence, the direction of interest rate shift from \(7 \%\) to \(8 \%\) makes intuitive sense.