7.2 The loanable funds theory of real interest rates

At the same time, the lack of capital in these countries means that the marginal

product of capital is likely to be high. Thus, we have a high demand for capital and

a low supply of domestic savings. Real interest rates are high. The reverse is true for

rich countries.

The differences persist because capital does not ow at all freely from rich to poor

countries. Capital is very mobile internationally only among developed countries.

There are many barriers to the movement of capital to developing countries, particu-

larly to the poorest of them. These include lack of information and the many risks

that investors face. Exchange rate risk is clearly important when we are discussing

the movement of capital from one country to another. This is the risk that the value

of the currency of the country to which capital is being exported will fall, resulting

in a capital loss when the owner of the capital later converts the funds back into his

own currency. It follows that interest rates in countries with currencies thought

likely to lose value over time include an exchange risk premium.

In addition to facing exchange rate risk, an investor may well fear default risk

much more in a foreign country than in his own economy. This may simply reect

a lack of information about the degree of risk in foreign countries. On the other

hand, default risk may objectively be much higher in developing countries that are

constantly short of foreign currency and have a history of unstable governments.

Firms nd it harder to plan under such circumstances and may have to deal with

frequent changes in regulations and taxes as well as rates of exchange.

Default risk refers specically to the failure of the borrower to repay a loan. Risk may

also arise from the actions of governments. For instance, governments may prevent

rms from taking funds out of the country in foreign exchange. There have also been

many examples of governments declaring a moratorium on the payment of interest

on loans or entering into agreements with creditors to reschedule loans so that they

are paid back over a much longer period than in the original agreement. These

types of risk are referred to as sovereign riskor country risk.Whatever the basis for this

increased risk, it is easy to see why the risk premium might vary from one country

to another. Consequently, real interest rates might vary greatly among countries.

It is even possible that mobile capital moves in the wrong direction – that it

moves to countries where rates of return are low but secure, causing differences in

real interest rates among countries to widen rather than to narrow as capital becomes

more mobile.

7.2.1Loanable funds and nominal interest rates

Let us next allow for the existence of ination and the need to distinguish between

nominal and real interest rates. Following the loanable funds approach, we con-

tinue to assume that people think in real terms. Now, however, the real value of the

nancial assets they hold changes with the rate of ination. It becomes important

for people to be able to move quickly from one form of asset to another in order to

protect the real value of the assets they hold. To do this, they need to hold part of

their assets in a liquid form. Thus, some borrowing takes place to allow the building

up of liquid reserves.

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Chapter 7 • Interest rates

At rst glance, this seems odd since the rate of interest received on such reserves

is bound to be less than that paid on loans. It is, however, a common phenomenon.

For example, many households with mortgages maintain liquid reserves – liquidity

has a value in itself and people are prepared to pay the spread between borrowing and

lending rates of interest in order to retain a degree of liquidity (see section 1.3.3).

It follows that the supply of loanable funds includes any rundown in existing liquid

reserves as well as the current savings of households and the retained prots of

rms. We also must now allow for the net creation of new money by banks since the

fractional reserve banking system greatly increases the ability of banks to lend.

For the economy as a whole, we can net out some items, leaving us with:

Demand for loanable funds net investment net additions to liquid reserves

Supply of loanable funds net savings increase in the money supply

We return next to Figure 7.1. Now, however, we allow for the possibility of ina-

tion and so the nominal interest rate shown on the axis might not be the same as

the real rate of interest. We assume that the lines DDand SSare the demand and

supply curves when ination is zero. Consider, then, what happens when the money

supply increases, ceteris paribus. This adds to the supply of loanable funds, the supply

curve moves down to SS. However, in the set of models of which loanable funds is

11

a part, the increase in the money supply ultimately only causes ination – it does not

cause an increase in output and employment. As prices rise, users of loanable funds

need to borrow more to buy the same quantities of capital and consumer goods as

before. The demand curve in Figure 7.1 shifts up to the right. We nish at point B,

with an equilibrium interest rate at i(equal to ithe rate of ination). The increase

31

in the money supply causes the nominal interest rate to rise but only because of the

ination it has caused. This is in accordance with the Fisher effect – lenders demand

higher nominal rates of interest to preserve the original real rate of interest and to

take ination into account.

The real interest rate does not change. Of course, we may take some time to reach

this position and the real rate of interest will be below its original level during the

period of adjustment. This persists, however, only to the extent that savers under-

estimate the true rate of ination (they suffer from money illusion) or require time

to alter the terms of savings contracts into which they have already entered.

Money illusion:A confusion between real and nominal values causing people not to

take ination fully into account. This is assumed to occur only in disequilibrium.

Proponents of this view assume that the monetary authorities have full control over

the supply of money (the money supply is exogenous) and so the initial increase in

the money supply and the consequent ination are the responsibility of the central

bank. Nominal interest rates are explained by a combination of the loanable funds

theory (explaining real interest rates) and a monetary theory of ination. Real interest

rates change only slowly over time. The only signicant disturbance to market interest

rates comes from the ill-advised activities of the monetary authorities.

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