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Figure 3.1CHAPTER 3THE LOANABLE FUNDS MODELThe next model in our series is called the Loanable Funds Model. This is a model of interest rate determination. Itallows us to explore the causes of rising and falling interest rates and to evaluate the wisdom of policy measures designed toinfluence credit and monetary growth rates and interest rates. In this chapter the model’s structure will explained and the useof the model illustrated through some examples.The Relevance of the Loanable Funds ModelHere are some important questions we can ask about interest rates:1.Why, generally, do interest rates rise and fall? What causal factors come into play, and how do they interact?2.What effects do budget deficits have upon interest rates?3.How does monetary policy, and in particular, expansionary open market operations, have upon interest rates?4.How does the formation of inflationary expectations influence interest rates? 5.When evaluating policies designed to affect interest rates or other financial variables, do we need to distinguish betweenthe long-run effects and the short-run effects of the policy?
Page 3.21In our simple applications of the model, we will typically be content to conclude that “the volume ofcredit rose” or “the volume of credit fell.”2These are sometimes called yield-bearing financial assets.3The mechanics of Federal Reserve policy and open market operations are too complex to describe here. Students will normally see an explanation of Federal Reserve policy in some other segment of a macroeconomicscourse. It must simply be accepted as a matter of faith here that the Federal Reserve System can, at will, increasethe supply of credit in the U.S. economy. is lost in this simplification, at least for the introductory applications for which the model is used, because the entire structureof interest rates tend to rise and fall together.