Financial Sector:Loanable Funds MarketAP EconomicsMr. Bordelon

Loanable Funds Market•Economists work with a simplified model in

which they assume that there is just one market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects).

•This hypothetical market is known as the loanable funds market.

•The price that is determined in the loanable funds market is the interest rate, denoted by r.

Loanable Funds Market

•Savers and borrowers care about the real interest rate because that is what they earn or pay after inflation.▫ Real interest rate = nominal interest rate – expected

inflation

•If expected inflation =0%, then real interest rate = nominal interest rate.▫If expected inflation is constant, any

change in the nominal rate will be reflected in an identical change in the real rate.

Demand for Loanable Funds Comes from BorrowersDemand is downward sloping. Firms borrow to pay for capital investment projects. If the project has an expected rate of return that exceeds the real interest rate, the investment will beprofitable, and the funds will be demanded.

Rate of return (%) = (Revenue from project – Cost of project)/(Cost of project) x 100%

As the real interest rate decreases, more projects become profitable, so the quantity of funds demanded will increase.

Similarly, if the project’s expected rate of return is below the real interest rate, investment will not be profitable and funds will not be demanded.

As the real interest rate increases, more projects become unprofitable, so the quantity of funds demanded will decrease.

Supply of Loanable Funds Comes from Savers Supply is upward sloping. Savers can lend their money to borrowers, but in doing so must forgo consumption.

In order to compensate for the forgone consumption, savers must receive interest income and as the realinterest rate rises, the opportunity to earn more income rises, so more dollars will be saved.

As the real interest rate rises, the quantity of funds supplied will increase.

Similarly, it may be costly in opportunity cost for savers to lend money, so they’ll keep it as cash on hand.

If the interest rate is too low, then the quantity supplied of loanable funds will decrease.

As the real interest rate decreases, the quantity of funds supplied will decrease.

Loanable Funds Market Equilibrium Equilibrium interest rate here is rE at which QE dollars are lent and borrowed.

Investment spending projects with a rate of return of rE% or more are funded.

Projects with a rate of return of less than rE% are not funded.

Only lenders willing to accept an interest rate of rE% or less will have their offers to lend funds accepted.

At rE%, quantity of loanable funds supplied equals quantity of loanable funds demanded. rE% in this graph is 8%, with $300 billion in funds lent and borrowed.

Investment spending projects with a rate of return of 8% or higher receive funding.

Those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted. Those who demand a higher interest rate do not.

Loanable Funds Market Equilibrium

Looking at this graph, at rE, quantity of loanable funds supplied equals quantity of loanable funds demanded. rE in this graph is 8%, with $300 billion in funds lent and borrowed.

Investment spending projects with a rate of return of 8% or higher receive funding.

Those with a lower rate of return do not.

Lenders who demand an interest rate of 8% or lower have their offers of loans accepted.

Those who demand a higher interest rate do not.

Shifts of Demand for Loanable Funds

Change in perceived business opportunities. A change in beliefs about the rate of return on investment spending can increase or reduce the amount of desired spending at any given interest rate.

If firms believe that the economy is booming, demand for loanablefunds will increase.

If firms believe the economy is tanking, demand for loanable funds will decrease.

Shifts of Demand for Loanable FundsChanges in government borrowing. Governments that run budget deficits are major sources of the demand for loanable funds.

If government runs a budget deficit, the Treasury must borrow funds and acquire more debt. This increases demand for loanable funds.

If government runs a budget surplus, less debt would be required and the demand for loanable funds decreases.

Crowding out. When a government deficit drives up interest rate and leads to reduced investment spending.

At higher interest rates, some investment will be “crowded out” by government demand for loanable funds.

Shifts of Supply of Loanable FundsChanges in private savings behavior. If households decide to consume more and save less, the supply of loanable funds will shift to the left.

If households decide to consume less and save more, the supply of loanable funds will shift to the right.

Changes in capital inflows. If a nation is perceived to have a stable government, a strong economy and is a good place to save money, foreign money will flow into that nation’s financial markets, increasing the supply of loanable funds.

If a nation is considered unstable, and is a bad place to save money, foreign money will flow out of the nation’s financial markets, decreasing the supply of loanable funds.

Inflation and Interest Rates• Anything that shifts either the supply of loanable

funds curve or the demand for loanable funds curve changes the interest rate.

• Dealing with unexpected inflation impacts borrowers and lenders. Economists apply the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate:▫ Real interest rate = Nominal interest rate — Inflation

rate For borrowers, the true cost of borrowing is the real

interest rate, not the nominal interest rate. For lenders, the true payoff to lending is the real

interest rate, not the nominal interest rate.

Fisher EffectFisher Effect. An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged. Each additional percentage point of expected future inflation drives up the nominal interest by that additional percentage point.

Both lenders and borrowers base their decisions on the expected real interest rate.

As long as the level of inflation is expected, it does not affect the equilibrium quantity of loanablefunds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.

Fisher Effect

Assume an expected inflation rate of 0%. This makes the equilibrium nominal interest rate as 4%. Increasing expected future inflation pushes both D and S upwards by 1 percentage point fore very increase in expected future inflation.

Here, D10 and S10 are the curves for when expected inflation is 10%. The 10% expected inflation raises equilibrium nominal interest rate to 14%. Expected real interest remains at 4%. QE remains unchanged.

Liquidity Preference and Loanable Funds Models Together—Short Run

Liquidity Preference and Loanable Funds Models Together—Short Run

1. On the liquidity preference model, a decrease in interest rates lead to an increase in investment spending, I, which then leads to an increase in both real GDP and consumer spending, C.

2. The increase in real GDP leads to an increase in consumer spending and also leads to an increase in savings. At each stage of the multiplier process, part of the increase in disposable income is saved.

3. According to the savings–investment spending identity, total savings in the economy is always equal to investment spending.

4. A decrease in the interest rate leads to higher investment spending, and the resulting increase in real GDP generates exactly enough additional savings to match the increase in investment spending.

5. After a decrease in the interest rate, the quantity of savings supplied increases exactly enough to match the quantity of savings demanded.

This analysis can be done in reverse when you see an increase in interest rates.

Liquidity Preference and Loanable Funds Models Together—Long Run

Liquidity Preference and Loanable Funds Models Together—Long Run

1. MS increases from M1 to M2. This reduces the interest rate to r2.2. In the long run , APL increases by same proportion as the increase in MS.3. An increase in APL increases MD in the same proportion. In the long run, MD curve shifts

out to MD2, and the equilibrium interest rate rises back to its original level, r1.4. In the loanable funds market, an increase in MS leads to a short-run increase in real GDP

and that shifts supply of loanable funds to the right from S1 to S2.5. In the long run, real GDP falls back to its original level as wages and other nominal prices

rise. As a result, the supply of loanable funds, S, which initially shifted from S1 to S2, shifts back to S1.

Liquidity Preference and Loanable Funds Models Together—the point!• In the short run, an increase in MS leads to a

decrease in the interest rate, and a decrease in the MS leads to an increase in the interest rate.

• In the long run, changes in MS don’t affect the interest rate. Both the money market and loanable funds markets are in equilibrium.

• In the long run, the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output.

Question 1• For each of the following scenarios, use a correctly

labeled graph to show how the market for loanable funds is affected. Show in your graph the impact on the equilibrium interest rate and quantity of loanable funds.▫ The Chair of the Federal Reserve testifies before

Congress that he/she expects the health of the economy to significantly improve in coming months.

▫ Households fear an imminent recession and begin to cut back on discretionary purchases.

▫ The Federal government announces another annual budget surplus.

▫ The flow of foreign financial capital into American financial markets begins to decrease.

Question 2

Use the market for loanable funds shown in the accompanying diagram to explain what happens to private savings, private investment spending, and the rate of interest if the following events occur. Assume that there are no capital inflows or outflows.a.The government reduces the size of its deficit to zero.b.At any given interest rate, consumers decide to save more. Assume the budget balance is zero.c.At any given interest rate, businesses become very optimistic about the future profitability of investment spending. Assume the budget balance is zero.

Question 3

The government is running a budget balance of zero when it decides to increase education spending by $200 billion and finance the spending by selling bonds. The diagram shows the market for loanable funds before the government sells the bonds. Assume that there are no capital inflows or outflows. How will the equilibrium interest rate and the equilibrium quantity of loanable funds change? Is there any crowding out in the market?

Question 4• In 2006, Congress estimated that the cost of the Iraq War

was approximately $100 billion a year. Since the U.S. government was running a budget deficit at the time, assume that the war was financed by government borrowing, which increases the demand for loanable funds without affecting supply. This question considers the likely effect of this government expenditure on the interest rate.▫ Draw typical demand (D1) and supply (S1) curves for loable

funds without the cost of the war accounted for. Label the vertical axis “interest rate” and the horizontal axis “quantity of loanable funds.” Label the equilibrium point (E1) and the equilibrium interest rate (r1).

▫ On the same graph, now include the cost of the war included in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point (E2) and the new equilibrium interest rate (r2).

▫ How does the equilibrium rate change in response to government expenditure on the war? Explain.