Final answer:
An increase in savings increases the supply of loanable funds, resulting in a lower interest rate, while a decrease in savings decreases supply and raises the interest rate, as illustrated in the loanable funds theory.
Step-by-step explanation:
How Changes in Savings Affect the Interest Rate
When considering how a change from savings 1 to savings 2 affects the interest rate, one must first understand the relationship between savings and interest rates within the economy. This concept is explained through the loanable funds theory, which is an economic model that depicts the market where borrowers and lenders interact. In this market, savings represent the supply of loanable funds, while investment demands those funds.
When savings in an economy increase, the supply of loanable funds also increases. This shift in the supply curve would typically result in a lower equilibrium interest rate. Conversely, if savings were to decrease, the supply curve would shift to the left, causing interest rates to rise as the supply of loanable funds contracts.
For example, imagine a scenario where households decide to increase their savings. With more funds available for lending, banks and other financial institutions experience a surplus of capital. To attract borrowers, they would lower the interest rates, which encourages investments and spending in the economy. If households then decide to save less (moving from savings 2 back to savings 1), the surplus of loanable funds diminishes, and interest rates would start to climb as lenders aim to ration the scarcer resources.
Understanding this dynamic is crucial for economists and policy makers as they attempt to influence economic conditions through monetary policy and other economic measures. Changes in interest rates can significantly impede or accelerate economic activity, impacting everything from consumer spending to business expansion and government borrowing.