As far as I understand, the majority of loan contracts specify a nominal interest rate, NOT a real interest rate. So a hypothetical loanable funds markets would have people suggesting potential borrowers different loan contracts with different nominal intrerest rates.
Why does the Loanable Funds Market model use the real interest rate instead of the nominal interest rate?
$\begingroup$ I’m not sure about the specifics of the model referred to, but based on other models, the answer is that this is required in order to relate future consumption to present. Even if one tries to create the model with nominal contracts, the assumption is that inflation expectations converts it to a real rate anyway. You are pointing out a discrepancy between the model and the real world. Whether these models have any relationship to the real world is disputed, but such disputes are not going to be solved here. $\endgroup$– Brian RomanchukAug 2, 2020 at 12:50
$\begingroup$ @BrianRomanchuk "the assumption is that inflation expectations converts it to a real rate anyway. " Can you elaborate or provide an example? $\endgroup$– KarmaPeasantAug 2, 2020 at 12:57
1$\begingroup$ As I wrote, I am not sure what is the exact model you are referring to. But in similar models, even if you have nominal interest rates, what matters for behaviour is the real rate. The model agents have an inflation expectations variable, then wave your hands and invoke equilibrium. Whether this has any bearing on on the real world is up to the reader. $\endgroup$– Brian RomanchukAug 2, 2020 at 15:54
$\begingroup$ @BrianRomanchuk I meant the same model as used by Khan Academy: khanacademy.org/economics-finance-domain/ap-macroeconomics/… $\endgroup$– KarmaPeasantAug 2, 2020 at 16:47
$\begingroup$ I’m a post-Keynesian. From that perspective, the linked model represents a good example of the limitations of economics 101 textbooks. Even neoclassical economists would probably point you to the models found in graduate level textbooks. However, if one is studying for an exam that uses that model, you would need to find someone who thinks the model is useful. $\endgroup$– Brian RomanchukAug 2, 2020 at 17:18
As Brian mentions in his comments this is because in standard models when people make intertemporal decisions they take inflation into the account. Take the following example:
You have a rational utility maximizing person who makes decision between consuming $\\\$100$ today or saving it for later consumption. For simplicity lets assume discount factor is exactly 1 (this is unrealistic as clearly consumption in the future should be valued less than in present but it just simplifies the math). Now let us suppose the nominal interest rate $i$ is $10\%$ and the question is should you save in this example or not?
Well the correct answer here is we dont have enough information to say yes or no. If inflation is $5\%$ the person should save those $\\\$100$ if inflation rate is $15\%$ the person should not do that because in the former case you will increase your resources in real terms after accounting for inflation and in the latter you will have less of them. Hence nominal interest rate can be any arbitrary number $x$ between $[0,\infty)$, but without knowing what inflation rate is we cannot say whether you should consume today or tomorrow (i.e. whether you should supply loanable funds to the market or not).
What matters is the real interest rate which is the nominal interest rate less the inflation rate since by Fisher equation: $r \approx i - \pi$ where $r$ is the real interest rate, $i$ nominal interest rate and $\pi$ inflation.
This covered just the supply side of loanable funds but the demand side would work in similar way. A business person would want to take loan for projects should analogously work with real returns and interest rates when evaluating business proposals.
I would not call this handwaving as Brian does which is commonly used in science to refer to addition to the model that are ad hoc or do not follow from assumptions of the model in consistent fashion but Brian is correct in saying that it is not necessarily exactly how reality works.
For example, it is documented that people can suffer from behavioral bias 'money illusion' which is cognitive bias to think of money in nominal, rather than real, terms. Under a 'money illusion' what the nominal rate is also matters in non-trivial ways. However, in simple macro 101 model which presents the classical view of loanable funds market where agents are rational forward looking and having rational expectations such money illusion does not exist.
Because the loanable funds theory, being developed within the framework of the neoclassical school, is focused on real variables instead of nominal ones. In this theory (that, I have to admit it, as a neoclassical guy I like a lot) the market equilibrium interest rate is determined by the marginal return on capital (which drives the demand for capital) and the marginal utility of exchanging present goods against future goods (which determines the supply of capital). The equilibrium rate matching savings to investment has been called the neutral or natural rate, that is the rate in which inflation is low and economy is at its potential output.
In short, the loanable funds model is a long run analysis of what happens in the capital markets and since it is a long run analysis it has to take into account the inflation dynamics