Two Models of Interest Rates?

You might have noticed that this is the second time we have discussed the determination of the interest rate. In Chapter 10 we studied the loanable funds model of the interest rate; according to that model, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct?

The answer is both. We explain how the models are consistent with each other in the appendix to this chapter. For now, let’s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy—actions by the Federal Reserve and other central banks—works.