Macroeconomic data do not show a strong correlation between investment and interest rates. Let’s examine why this might be so. Use our model in which the interest rate adjusts to equilibrate the supply of loanable funds (which is upward sloping) and the demand for loanable funds (which is downward sloping).
a. Suppose the demand for loanable funds is stable but the supply fluctuates from year to year. What might cause these fluctuations in supply? In this case, what correlation between investment and interest rates would you find?
b. Suppose the supply of loanable funds is stable but the demand fluctuates from year to year. What might cause these fluctuations in demand? In this case, what correlation between investment and interest rates would you find now?
c. Suppose that both supply and demand in this market fluctuate over time. If you were to construct a scatterplot of investment and the interest rate, what would you find?
d. Which of the above three cases seems most empirically realistic to you? Why?