Affect of Interest rate on Equilibrium in Short and Long Run - Essay Example

The economy is said to be in equilibrium when supply and demand are equal i.e. when the supply function and demand function intersect (fig.1).

Fig 1: Equilibrium (E) where price (P) of the apartment is P’ and the quantity (Q) in the market is Q’

Equilibrium in Short-Run

A rise in interest rate means borrowing and spending become less attractive and saving becomes more attractive.  Subsequently, lesser activity is seen in the economy.  For constructors of residential apartments, this would mean a decrease in demand.  At this stage, it is assumed that the supply and the cost of the apartments remain constant.

As the price and the supply remain constant, the whole demand curve will shift.  As the demand decreases, this shift will be on the left side (fig.2).

Fig 2: A shift in demand from D to D’. This results in a decrease in quantity from Q to Q’.

As the supply remains constant, this shift in demand will result in a new equilibrium (fig.3).Fig 3: As the Demand curve shifts from D to D’ this changes the market equilibrium from E to E’.  This will reduce the market price of the apartment from P to P’.

Constructers will be able to provide more value for the same price to the customers.  Also, many of the customers who might have refused to invest in property initially when the interest price increased would now be more in terms with the market and willing to invest.  In the longer run, an increased interest rate would have made its impact of controlling inflation, and prices for other goods would be more stable.   All these factors would result in increasing the demand and would result in a shift in the demand curve to the right (fig.5).

Fig 5: Demand curve shifts from D’ to D’’.

The resulting shift in the demand curve and supply curve will result in a new equilibrium.

Fig 6: As the supply curve shifts from S to S’ and demand from D’ to D’’, this causes a new equilibrium in the market. 

It is worth noting that at this stage, there might not be a significant difference in price due to the combined influence of the two.