Monetary-disequilibrium Theory - Monetary-equilibrium, Loanable Funds and Interest Rates

Monetary-equilibrium, Loanable Funds and Interest Rates

In case of loanable funds market we need to discuss to concepts ex-ante and ex-post. Ex-ante is what people desire and ex-post is what happens in the market process. In case of market equilibrium what demanders wish to do is exactly equal to what suppliers wish to do. This has been shown in the figure. The equilibrium here is ex-ante. However it does not guarantee that ex-post will match it especially if entrepreneurs are prevented from finding the price that will bring equilibrium in the market. Let us take the case of price ceiling. At that price quantity demanded will exceed the quantity supplied resulting in a ex-ante disequilibrium.

If the market process proceeds in this scenario we will see that the amount bought equals the amount sold and there is an ex-post equality. This happens because demanders are unable to make their demands effective due to the price ceiling.

In loanable funds market equilibrium ex-ante plans of savers and investors match precisely. The monetary equilibrium has implications for the rate of interest as there is a distinction between market rate of interest and natural rate of interest. The market rate of interest is the rate that the banks are actually charging in the loanable funds market while natural rate of interest corresponds to the time preferences of savers and borrowers as expressed in demand-supply presentation for loanable funds (r* in the figure).

The monetary system is not a source of disturbance when there is monetary equilibrium but at the time of monetary disequilibrium the system becomes a source of disequilibrium by distorting the sources generated during the process of turning time-preferences into the demand and supply for loanable funds. For ex-ante and ex-post quantities to be equal someone has to lose out.In addition the adjustment process entails significant social costs. Now, let us suppose there is an excess supply in the market. Banks will create more loanable funds than people's real willingness to save as determined by their time preferences. This will result in a fall in the market rate of interest as banks will try to lure new borrowers with their excess money supply, but the natural rate remains the same as no additional supply of loanable funds have come from the public.

Read more about this topic:  Monetary-disequilibrium Theory

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