Download - The Market for Loanable Funds
THE MARKET FOR LOANABLE FUNDS
The Market for Loanable Funds
For the economy as a whole, savings always equals investment spending
In a closed economy, savings is equal to national savings
In an open economy, savings is equal to national savings plus capital inflow
Equilibrium Interest Rate
The Loanable funds market is a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
Equilibrium Interest Rate
The price that is determined in the loanable funds market is the interest rate, r.
It is the return that a lender receives for allowing borrowers the use of a dollar for one year, calculated as a percentage of the amount borrowed
Equilibrium Interest Rate
The rate of return on a project is the profit earned on the project expressed as a percentage of its cost.
A business will want a loan when the rate of return on its project is greater than or equal to the interest rate
Interest rate
12%
4
0 $150 450Quantity of loanable
funds(billions of dollars)
Demand for loanable funds, D
Interest rate
12%
4
0 $150 450Quantity of loanable funds(billions of dollars)
Supply of loanable funds, S
Equilibrium Interest Rate
Savings incur an opportunity cost when they lend to a business; the funds could instead be spent on consumption
Whether a given individual becomes a lender by making funds available to borrowers depends on the interest rate received in return
Equilibrium Interest Rate
The equilibrium interest rate is the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded
Interest rate
12%
8
4
0$300 Quantity of loanable
funds(billions of dollars)
Offers not accepted fromlenders who demand interestrate of more than 8%.
Projects with rate of returnless than 8% are not funded.
Projects with rate of return8% or greater are funded.
Offers accepted fromlenders willing to lend atinterest rate of 8% or less.
r*
Q*
Equilibrium Interest Rate Match up of funds is efficient1. The right investments get made: the
investment spending projects that are actually financed have higher rates of return than those that do not get financed
2. The right people do the saving: the potential savers who actually lend funds are willing to lend for lower interest rates than those who do not
Shifts of the Demand for Loanable Funds
1. Changes in perceived business opportunities
Business opportunities in the 90s with the Internet
2. Changes in government’s borrowing Changes in budget deficits can shift the
demand curve
An Increase in the Demand for Loanable Funds
Interest rate
r2
r1
Quantity of loanable funds
(billions of dollars)
An increase
in the demand
for loanablefunds . . .
. . . leads toa rise in theequilibriuminterest rate.
Shifts of the Demand for Loanable Funds
Fact that an increase in the demand for loanable funds leads, other things equal, to a rise in the interest rate has one especially important implication:Beyond concern about repayment, there
are other reasons to be wary of government budget deficits
Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending
Shifts of the Supply of Loanable Funds
1. Changes in private savings behavior: Between 2000 and 2006 rising home prices in the United States made many homeowners feel richer, making them willing to spend more and save less This shifted the supply of loanable funds to the left.
2. Changes in capital inflows: The U.S. has received large capital inflows in recent years, with much of the money coming from China and the Middle East. Those inflows helped fuel a big increase in residential investment spending from 2003 to 2006. As a result of the worldwide slump, those inflows began to trail off in 2008.
Interest rate
r1
r2
Quantity of loanable funds(billions of dollars)
An increasein the supply of loanablefunds . . .
. . . leads toa fall in theequilibriuminterest rate.
Inflation & Interest Rates
Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate.
Historically, major changes in interest rates have been driven by many factors, including:changes in government policy. technological innovations that created new
investment opportunities.
Inflation & Interest Rates
However, arguably the most important factor affecting interest rates over time is changing expectations about future inflation.
This shifts both the supply and the demand for loanable funds.
This is the reason, for example, that interest rates today are much lower than they were in the late 1970s and early 1980s.
Inflation & Interest Rates
Real interest rate = nominal interest rate - inflation rate
In the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal. Actual loan contracts, therefore, specify a nominal interest rate rather than a real interest rate.
Inflation & Interest Rates
According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.
The central point is that both lenders and borrowers base their decisions on the expected real interest rate
The Fisher EffectNominal interest rate
Quantity of loanable funds
Q*
14%
4
0
E10
S10
S0
D0
E0
D10
The Interest Rate in the Short Run
As explained before, using the liquidity preference model, a fall in the interest rate leads to a rise in investment spending, I, which then leads to a rise in both real GDP and consumer spending, C
The rise in real GDP doesn’t lead only a to a rise in consumer spending but it also leads to a rise in savings, at each stage of the multiplier process, part of the increase in disposable income is saved
The Interest Rate in the Short Run
How much do savings rise? Savings-investment spending identity
states that total savings in the economy is always equal to investment spending
When a fall in interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending
The Interest Rate in the Short Run
In the short run, the supply and demand for money determine the interest rate, and the loanable funds market follows the lead of the money market
When a change in the supply of money leads to a change in the interest rate, the resulting change is real GDP causes the supply of loanable funds to change as well
Interest Rates in the Long Run
In the long run, changes in the money supply don’t affect the interest rate
Interest Rates in the Long Run
What determines the interest rate in the long run is supply and demand for loanable funds
In the long run, the equilibrium interest rate is the rate that matches the supply of loanable funds with the demand for loanable funds when real GDP equals potential output