With the use of supply and demand curves, explain how interest rates are determined (Loanable Funds Theory).

To understand interest rates determination through Loanable Funds Theory, we must first define important concepts: - Interest rates: The cost of borrowing money or the return on an investment. - Supply of loanable funds: Refers to the funds available for lending, generally coming from savings and investments. - Demand for loanable funds: Refers to the funds sought for borrowing, usually for investment purposes like business expansion, consumption, and government projects.

The supply curve of loanable funds shows the relationship between the interest rate and the quantity of loanable funds supplied in the market. As interest rates increase, people are more incentivized to save and invest, leading to a greater supply of loanable funds. Conversely, lower interest rates make saving less attractive, decreasing the supply of loanable funds. Therefore, the supply curve has a positive slope, as it moves upward from left to right.

The demand curve of loanable funds represents the relationship between the interest rate and the quantity of loanable funds demanded. Higher interest rates result in higher borrowing costs and, consequently, less demand for loanable funds. On the other hand, lower interest rates make borrowing more attractive, leading to an increase in demand for loanable funds. Hence, the demand curve exhibits a negative slope, as it moves downward from left to right.

The equilibrium interest rate is determined when the supply and demand for loanable funds are equal. At this point, the market reaches a balance, and there is no surplus or shortage of funds. To find this point, plot the supply and demand curves, and the point at which they intersect indicates the equilibrium interest rate and loanable funds quantity.

External factors can cause shifts in the supply and demand curves, leading to changes in the equilibrium interest rate. Some of these factors include: - Economic growth: A growing economy leads to increased confidence, investment, and higher demand for loanable funds, shifting the demand curve to the right. - Government policy: Changes in fiscal and monetary policies, such as taxation changes and reserve requirements, can affect both the supply and demand for loanable funds. - Business confidence: Positive business sentiment can increase the demand for loanable funds for investment, shifting the demand curve to the right.

When the supply or demand curve shifts, it results in a change in the equilibrium interest rate. If the supply curve shifts to the right or the demand curve shifts to the left, the equilibrium interest rate will decrease due to an increase in the supply of loanable funds or a decrease in demand for loanable funds. Conversely, if the supply curve shifts to the left or the demand curve shifts to the right, the equilibrium interest rate will increase due to a decrease in the supply of loanable funds or an increase in demand for loanable funds. In conclusion, interest rates are determined by the balance between supply and demand for loanable funds in an economy. This interaction, represented by supply and demand curves, allows us to visualize how changes in various factors affect interest rates.