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 ID: 710511
Download Presentation The PPT/PDF document "The Market for Loanable Funds" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
The Market for Loanable FundsSlide2
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 inflowSlide3
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 lendersSlide4
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 borrowedSlide5
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 rateSlide6
Interest rate
12%
4
0
$150 450
Quantity of loanable funds
(billions of dollars)
Demand for loanable funds,
DSlide7
Interest rate
12%
4
0
$150 450
Quantity of loanable funds
(billions of dollars)
Supply of loanable funds,
SSlide8
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 returnSlide9
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 demandedSlide10
Interest rate
12%
8
4
0
$300
Quantity of loanable funds
(billions of dollars)
Offers not accepted from
lenders who demand interest
rate of more than 8%.
Projects with rate of return
less than 8% are not funded.
Projects with rate of return
8% or greater are funded.
Offers accepted from
lenders willing to lend at
interest rate of 8% or less.
r*
Q*Slide11
Equilibrium Interest Rate
Match up of funds is efficient
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
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 notSlide12
Shifts of the Demand for Loanable Funds
Changes in perceived business opportunities
Business opportunities in the 90s with the Internet
Changes in government’s borrowing
Changes in budget deficits can shift the demand curveSlide13
An Increase in the Demand for Loanable Funds
Interest rate
r
2
r
1
Quantity of loanable funds
(billions of dollars)
An increase
in the demand
for loanable
funds . . .
. . . leads to
a rise in theequilibrium
interest rate.Slide14
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 spendingSlide15
Shifts of the Supply of Loanable Funds
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
.
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.Slide16
Interest rate
r
1
r
2
Quantity of loanable funds
(billions of dollars)
An increase
in the supply of loanable
funds . . .
. . . leads to
a fall in the
equilibrium
interest rate.Slide17
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.Slide18
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.Slide19
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.Slide20
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 rateSlide21
The Fisher Effect
Nominal interest rate
Quantity of loanable funds
Q*
14%
4
0
E
10
S
10
S
0
D
0
E
0
D
10Slide22
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 savedSlide23
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 spendingSlide24Slide25Slide26
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 wellSlide27
Interest Rates in the Long Run
In the long run, changes in the money supply don’t affect the interest rateSlide28Slide29Slide30
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