Business Economics · Role of money and interest rates in the economy

Determination of Interest Rates: Money Market, Loanable Funds and the Fisher Equation

Updated 11 October 2026 · Fact-checked

An interest rate is the price of borrowing money. In the money market it settles where money supply equals money demand. In the loanable funds view it settles where saving equals borrowing. The Fisher equation links the nominal rate to the real rate and expected inflation: i ≈ r + πe.

Understand Determination of Interest Rates

An interest rate is the price paid for using money for a period. Like any price, it comes from demand and supply. The question is which demand and supply you look at. CB2 tests two views.

The first is the liquidity preference (money market) view, from Keynes. Money demand is the wish to hold money rather than bonds. Holding money gives no interest, so the interest rate is the cost of holding it. A higher rate means people hold less money. Money demand therefore slopes down against the interest rate. A higher income or price level shifts it right. The central bank controls money supply, so the supply curve is a vertical line. The rate settles where the two curves cross.

If the rate is above equilibrium, people hold less money than is supplied. They buy bonds, bond prices rise and the rate falls. If the rate is below equilibrium, people want more money than exists. They sell bonds, bond prices fall and the rate rises. If the central bank raises money supply, the vertical line moves right and the rate falls, other things equal.

The second is the loanable funds view, from the classical tradition. Supply of loanable funds comes from saving and slopes up. Demand comes from firms borrowing to invest, plus government borrowing. It slopes down. The rate settles where saving equals borrowing. More thrift shifts supply right and lowers the rate. Better investment prospects or a bigger government deficit shift demand right and raise the rate. The money market view is about the stock of money. The loanable funds view is about flows of saving and investment.

Next, nominal versus real. The nominal rate is the rate quoted in rupees. The real rate is the gain in purchasing power after inflation. The Fisher effect says that if expected inflation rises, lenders ask for a higher nominal rate to protect the real return. Over the long run, the real rate is set by real factors and the nominal rate moves one for one with expected inflation. In the short run, prices may be sticky, so the link can be looser. Borrowers and lenders decide on expected inflation, so the ex-ante real rate uses expected inflation. The ex-post real rate uses actual inflation.

In practice there is not one rate. Rates differ by risk, term and liquidity. The central bank sets a policy rate and market rates follow it through arbitrage.

Key rules to remember

Money market equilibrium: Ms = L(i, Y, P); Ms is the money supply set by the central bank. L is liquidity preference (money demand), falling in i and rising in income Y and the price level P. The equilibrium i clears the market.
Loanable funds equilibrium: S(r) + capital inflows = I(r) + government borrowing; Saving supplies funds. Investment and government deficits demand them. In a closed economy, drop capital inflows. The equilibrium rate clears the market.
Fisher equation (approximate): i ≈ r + πe; i is the nominal rate, r the real rate and πe expected inflation. Use for small rates.
Fisher equation (exact): (1 + i) = (1 + r)(1 + πe); Rearranged: r = (1 + i) ÷ (1 + πe) − 1. Use when rates or inflation are high or the question asks for an exact answer.
Ex-post real rate: r (ex post) ≈ i − π (actual); Uses actual inflation after the event, not expected inflation.

How to solve Determination of Interest Rates questions

Use this method for any question on how interest rates are set or how they change.

1Identify the framework the question wants: money market (liquidity preference), loanable funds, or Fisher (real vs nominal). If it is not stated, say which you use.
2Name the two curves. Money market: vertical money supply and downward-sloping money demand. Loanable funds: upward-sloping saving and downward-sloping investment plus borrowing.
3Find the shock and decide which curve it moves, and in which direction. Write the reason in one line.
4Show the new equilibrium and state whether the interest rate rises or falls, with the adjustment mechanism (bond prices for the money market, excess saving or borrowing for loanable funds).
5For numerical Fisher questions, check whether the rates are nominal or real and expected or actual. Then choose the approximate or exact form.
6Compute carefully, giving the answer as a percentage to a sensible number of decimals.
7State assumptions, such as other things equal, closed economy, or fixed price level, and add a brief comment on the business impact.

Quickest way: Shift the curve, then read the rate

When to use it: Use this for multiple-choice questions on the direction of interest rate changes, and for quick Fisher calculations.

Ask: does this shock change money supply, money demand, saving or investment?
Apply the simple rule. More money supply lowers the rate. More money demand raises it. More saving lowers it. More investment or government borrowing raises it.
For Fisher, add expected inflation to the real rate for the nominal rate. Subtract it for the real rate.
If an option uses actual inflation where expected inflation is needed, reject it.
If the numbers are large, use (1 + i) = (1 + r)(1 + πe). Otherwise the approximation is fine unless the question says exact.

Common mistakes in Determination of Interest Rates

Drawing money supply as upward sloping when the central bank sets it
Students copy the shape of an ordinary goods market supply curve.
Fix: In the standard liquidity preference diagram, the central bank fixes money supply, so draw it vertical. Say so explicitly.
Confusing a shift of money demand with a movement along it
The interest rate is on the axis, so a change in the rate looks like a shift.
Fix: A change in the interest rate moves you along the curve. A change in income or prices shifts the curve. Name the cause before drawing.
Mixing real and nominal rates in Fisher questions
Questions quote one rate and ask for another, and the words are similar.
Fix: Write the labels i, r and πe beside each number before you calculate. Rearrange only after that.
Using actual inflation when the question asks for the expected real rate
Students treat the last observed inflation as the forecast.
Fix: Use expected inflation for ex-ante rates and actual inflation for ex-post rates. Check the wording.
Saying the two theories give opposite answers
They are taught side by side as rivals.
Fix: They are different views of the same market: one focuses on money stock and the other on saving and borrowing flows. Say they can give different short-run results, and compare them by their focus and time frame.
Saying a rise in money supply always lowers rates in the long run
The short-run result is taken as permanent.
Fix: Add that higher money growth may raise expected inflation, and by the Fisher effect that can raise nominal rates later.

Worked examples

Example 1

The nominal interest rate is 9% a year and expected inflation is 4%. Find the real interest rate (a) using the approximate Fisher equation and (b) using the exact Fisher equation.

Show the solution

Label the data: i = 9%, πe = 4%.
(a) Approximate: r ≈ i − πe = 9% − 4% = 5%.
(b) Exact: 1 + r = (1 + i) ÷ (1 + πe) = 1.09 ÷ 1.04.
1.09 ÷ 1.04 = 1.048077, so r = 0.048077, which is 4.81% to two decimals.
Compare: the approximation overstates the real rate by about 0.19 percentage points.

Answer: Approximate real rate: 5%. Exact real rate: about 4.81%.

Example 2

In a closed economy, the central bank raises the money supply while income and prices stay constant. Using the money market model, explain what happens to the interest rate and to firms' borrowing costs. Then say what the Fisher effect adds if the public now expects higher inflation.

Show the solution

Set up: money supply is a vertical line. Money demand slopes down in the interest rate. The starting equilibrium is where they cross.
Shock: higher money supply shifts the vertical line right. Income and prices are fixed, so money demand does not move.
At the old rate, people hold more money than they want. They use the surplus to buy bonds.
Bond prices rise, so the interest rate falls until money demand equals the new, larger supply.
Result: lower interest rate. Firms face lower borrowing costs, so investment may rise, other things equal.
Fisher addition: if the public expects higher inflation, lenders ask for a higher nominal rate, i ≈ r + πe. This can offset the fall, especially over a longer period.

Answer: The interest rate falls in the short run, which lowers borrowing costs. If higher inflation is expected, the Fisher effect pushes the nominal rate up and can partly or fully offset the fall.

Exam tips

Always say which model you are using and name the two curves before you give a direction of change.
Draw a small, labelled diagram in written answers: axes, curve names, old and new equilibrium. Then explain the adjustment in words.
In Fisher questions, write i, r and πe next to each number first. Check whether the question wants approximate or exact.
For compare questions, give the focus and the time frame: stock of money versus flow of saving and borrowing.
Add one sentence on business impact, such as a lower rate reducing the cost of capital, when the question links to firms.

Practice questions from Role of money and interest rates in the economy

Determination of Interest Rates in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ACCA Applied SkillsInterest Rates and Yield Determination

Determination of Interest Rates: frequently asked questions

How are interest rates determined in the money market?

The central bank fixes money supply, shown as a vertical line. Money demand falls as the interest rate rises. The rate settles where the two are equal. Bond price changes move the rate to that point.

What is the difference between loanable funds and liquidity preference theory?

Loanable funds says the rate balances saving with borrowing for investment and government needs. Liquidity preference says the rate balances the supply of money with the demand to hold it. One looks at flows of funds and the other at the stock of money.

What is the Fisher equation?

It links the nominal rate i, the real rate r and expected inflation πe. The approximate form is i ≈ r + πe. The exact form is (1 + i) = (1 + r)(1 + πe).

What is the difference between real and nominal interest rates?

The nominal rate is the quoted rate in money terms. The real rate removes the effect of inflation, so it shows the gain in purchasing power. A high nominal rate can still mean a low real rate if inflation is high.