What is all this economic gibberish about?

I know, I said I wasn’t going to  focus on academic concepts. But after seeing how some at work don’t fully understand some of the underlying economic concepts, I’ll talk about them and try to keep it as simple and basic as possible.

It stemmed from this sort of dual-complaint after sharing this article with some colleagues:

  1. the government is creating/spending too much money
  2. interest rates need to stay low

So I will introduce something called the Loanable Funds Model. It is a basic economic model that allows us to examine what determines interest rates. If you aren’t familiar with the concept or model, don’t feel intimidated by the graph, it is actually pretty simple.

Loanable Funds ModelThe way it works is that along the left side is the interest rate, and along the bottom is the volume of funds, or amount of funds. DF signifies the demand for those funds, and SF signifies the supply of those funds. So far so good?

Where the demand and the supply intersect is the interest rate and the amount of funds “out there”.

So let’s say the Federal Reserve decides they want interest rates to be really low. To do that they would most likely have to add a bunch of money into the money system in various ways. That would increase the supply (SF), making the supply line shift to the right.

Loanable Funds ModelFrom the new intersection point we can see that the interest rates drop, while the amount of funds is increased. Now typically if there is an increase in the supply, there would be an increase of loans and spending which would increase demand for those funds.

Loanable Funds ModelThe increase in demand(DF) moves the line right. So in the end we eventually get back to the same interest rates, just with a lot more funds out there – which with more funds out there would most likely cause inflation.

Of course this is just a simple explanation, there are many more factors involved such as interest on reserves, etc., but this covers some of the major basics. So when you hear things about interest rates and inflation this should give you a better picture of what is really going on.

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