A Downturn Sinks Expected Profits
Firms expect weak profits from new capital, so fewer projects are worth financing: the demand for loanable funds falls and the real interest rate drops.
A Downturn Sinks Expected Profits
Loanable Funds MarketFirms expect weak profits from new capital, so fewer projects are worth financing: the demand for loanable funds falls and the real interest rate drops.
Equilibrium at Quantity of Loanable Funds 73, Real Interest Rate (%) 5
Start at Equilibrium
The market opens in equilibrium with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. The demand curve is really the investment schedule: a firm borrows for a project when the return it expects beats the real interest rate it must pay.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
A Downturn Sinks Expected Profits, step by step
- 1
Start at Equilibrium
The market opens in equilibrium with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. The demand curve is really the investment schedule: a firm borrows for a project when the return it expects beats the real interest rate it must pay.
- 2
Expected Profits Collapse
Orders dry up and firms slash their forecasts, so the expected return on a new factory or delivery fleet drops. Projects that once beat the going rate no longer do. At every real interest rate firms want to borrow less, so the demand for loanable funds shifts left. This is a genuine shift because the expected return changed, not the price of borrowing.
- 3
The Real Interest Rate Falls
With fewer borrowers competing for the same pool of saving, the equilibrium slides down along the supply curve. The real interest rate falls and the equilibrium quantity of funds borrowed and lent falls too. Both the price and the quantity drop, which is the signature of a leftward demand shift.
- 4
Saving Falls Along the Supply Curve
The lower real interest rate makes lending less rewarding, so savers supply fewer funds. Do not draw that as a leftward shift in supply: it is a movement down along the supply curve caused by the new lower rate. Note the contrast with a saving shock, where the real interest rate and the quantity of funds move in opposite directions instead of falling together.
Where it ends up
Falling expected profits reduce investment demand, so the real interest rate and the equilibrium quantity of loanable funds both fall.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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