Fiscal Policy = Loanable Funds = Real Interest Rate
Monetary Policy = Money Market = Nominal Interest Rate
1) Loanable Funds
Loanable funds graph has the real interest on the vertical axis and the quantity of loanable funds on the horizontal. The supply curves show the amount of loanable funds that people have saved and are willing to loan. The demand curve is the businesses and individuals that would like to borrow.
Equilibrium shows the real interest rate for the country.
The real rate of interest is crucial in making investment decisions. Business firms want to know the true cost of borrowing for investment. If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation, and the inflation rate is negative, then the real interest rate will be larger. (Pride)
Loanable Funds = Money in banks that can be loaned out to individuals and firms
The real rate of interest is: (an eye on the price level/inflation)
- the opportunity cost of borrowing/loaning money
- expressed in constant dollars (inflation adjusted value)
- value or purchasing power of money used
- percentage increase in purchasing power the borrower pays (adjusted for inflation)
The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest.
The supply of loanable funds is based on the savings of the private sectors.
2) Money Market
The money market graph has nominal interest rate on the vertical axis and the horizontal axis is labeled the quantity of money. The supply of money is perfect inelastic as the money supply is controlled by the FED. The demand for money curve is downward sloping. Price level changes will effect the demand for money as will interest rate changes.
The nominal rate of interest is:
- the opportunity cost of holding money
- expressed in current dollars (non-inflation adjusted value)
- price paid for the use on money (no eye on inflation)
- percentage increase in money the borrower pays (not adjusted for inflation)
The supply of money is based on the actions of the FED.
Why Nominal rates ?? - the money supply deals with inflation and nominal value, not real value, while an increase in the money supply is the cause of Price level changes (inflation).
In the long run an increase in the Money Supply will cause the demand for money to increase and the Nominal Interest Rate to rise.