Download The Loanable Funds Market

Chapter 26: Saving, Investment, and the Financial System
The capitalistic economy ‘s dependence on the use of capital goods in producing
output has been noted various times in previous chapters. In fact, the reliance on
the extensive use of capital was identified as a source of significant growth for a
number of wealthy, developed and economically viable nations.
This chapter delves into the structure and mechanics of a system (the economy’s
“loanable funds”) that finances and otherwise pays for needed business
investment in capital goods.
Special emphasis is placed on a number of financial institutions, such as the bond
market, the stock market, banks, and mutual funds that help feed the so-called
stock of loanable funds used to finance investment expenditures. Each of these
can be characterized as either: 1) “Financial Markets” or 2) “Financial
Intermediaries”
The behaviors of the suppliers of loanable funds (saving households who desire to
lend their unspent income) along with the factors that impact their saving activity
are identified.
The behaviors of those who demand loanable funds (households and firms who
wish to borrow) along with the factors that influence their desires to borrow are
also identified.
Finally, a simplified interest rate determination model is constructed and the
potential impact of government budget deficits is examined.
More to follow……….
Students should lay particular focus on the following key concepts:
The Components of Financial Markets (The Bond Market and the Stock Market)
The definition and specific characteristics of the bond market to include:
1) The definition of a bond
2) The concept of “debt finance”
3) A bond’s “term”;
4) The interest rate a bond pays (and how the length of the bond term affects
the interest rate;
5) The “credit risk” associated with a bond and how that risk affects the bond
interest and
6) The tax treatment of various bonds and how tax-related issues affect bond
interest rates.
The definition and specific characteristics of the stock market to include:
1) The definition of a stock
2) The concept of “equity finance”
3) A comparison of “stock risk” vs. “bond risk”:
4) How perception of a corporation’s future profitability affects the demand for a
stock and therefore its stock’s price
The Components of Financial Intermediaries (i.e. Banks and Mutual Funds)
U.S. Banks are corporate entities (lending / depository institutions) that, in the
eyes of the law, have a recognized existence separate and distinct from that of its
owners. They accept bank customer deposits for which they pay depositors rates
of interest. They then lend those deposits to borrowers at slightly higher rates of
loan interest.
As a general rule only corporations can sell stock or bonds in order to finance
investment expenditure. Even smaller corporations with poor profit history might
encounter difficulty in selling their stock. As such, smaller/poor performing
corporations, sole proprietorships, and partnerships (all unable to sell stock) are
faced with a last resort of bank loans to finance investment expenditures.
Mutual Funds are institutions that sells “shares” in itself to the public and uses
the proceeds to buy and manage portfolios or bundles of corporate stocks and
bonds. Corporations who sell their stocks to mutual fund managers use stock sale
proceeds to finance investment expenditures.
The Loanable Funds Market represents the totality of funds that financial
markets (stocks and bonds) and financial intermediaries (banks and mutual funds)
channel or direct to borrowers (firms and households) to finance investment
expenditures.
Students should master the following concepts:
1) How saving (deposits in banks, purchases of stocks, purchases of bonds, and
purchases of mutual funds) represents the “Supply of Loanable Funds”;
2) How and why the “Supply of Loanable Funds” curve is upward-sloping (i.e. how
interest rates paid to savers affect the desire by save)
NOTE WELL: There is an expanded definition of “INVESTMENT” that was actually
mentioned briefly in a previous chapter that should be acknowledged to wit:
“Investment during a given calendar year includes expenditures on new tools,
machinery, and equipment (human-made tools used to produce or to sell goods
and services), expenditures/purchases by firms on inventory, and expenditures
on all types of new construction (to include business and residential
construction);
3) How the demand for loanable funds is derived from funds used to finance
investment expenditures, i.e. purchases by households (mortgage loans) and
purchases of capital goods and new inventory by business firms and
4) How and why the “Demand for Loanable Funds” curve is downward-sloping
(i.e. how the interest rates charged by lenders/banks on loans affects the volume
of loan activity)
Students should also understand how interest rates will “move” when the
quantities of loanable funds made available by savers are greater than the
quantities desired by borrowers for loans.
Finally, students should also understand how interest rates “move” when the
quantities of loanable funds desired by borrowers is greater than the quantities of
loanable funds are greater than the volume of loanable funds made available by
savers.
In the case of the interest rate determination process students should understand
how equilibrium interest rates tend to “equilibrate” the quantities of loanable
funds by savers and borrowers.
An Overview of U.S. Saving Patterns – Students Should Also Understand and
Recognize:
The U.S. record of saving
Why, according to most economists, saving rates are so low.
The impact of tax cut policies (i.e. tax cuts on interest income) on the
desire/incentive to save AND on equilibrium interest rates
An Overview of U.S. Investment Expenditure Patters – Students Should Also
Understand and Recognize:
The mechanics of an “investment tax credit”
How an investment tax credit would affect:
1) the demand for loanable funds and why? And
2) investment expenditures and why? And
3) interest rates and saving levels and why?
More to follow……
An Overview of U.S. Government Budget Deficits, How Those Deficits are
“Financed” and the Impact of Those Deficits on Equilibrium Interest Rates in the
Loanable Funds Market
Students should clearly understand:
The definition of a U.S. Federal government budget deficit and why it might exist
How the U.S. government “finances” its yearly budget deficits
How the economy-wide stock of loanable funds is affected when the U.S. Federal
government finances those deficits through bond sales.
How equilibrium interest rates in the loanable funds market are affected by U.S.
government deficit spending policies and resulting borrowing
How higher equilibrium interest rates in the loanable funds market impact private
investment borrowing and spending by U.S. firms.
Ultimately, how U.S. government deficit spending and how it is financed affects
long-term U.S. growth.