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UNIT 5 –
FINANCIAL SECTOR
TEST: APRIL 14 (POST LUNCH)
SAVINGS, INVESTMENT, AND THE
FINANCIAL SYSTEM
• Day 1
• Learning Goals
• The relationship
between savings and
investment spending
• The purpose of the
five types of financial
assets
• How financial
intermediaries help
investors achieve
diversification
SAVINGS AND INVESTMENT SPENDING
• When firms invest in physical capital (tractors, factories,
etc) the firm usually pays for these items via
borrowing…those funds have to come from somewhere
• Savings – Investment spending is always: S=I
• This is known as the savings-investment identity
• This sort of goes back to the circular flow diagram…
• Let’s say we are in a simple economy with no
government and no trade
• Total income = C + I
• Now, what do people do with income, they either spend it, or
save it…
• Total income = C + S = Total Spending = C + I
• C+S = C + I
• Simplified is S = I
WHAT ABOUT AN ECONOMY WITH A
GOVERNMENT?
• Government also spends money and pays transfers,
they collect revenue to do this
• If the government has a balanced budget:
• Tax revenue = government spending + transfer payments
• Or
• Budget Balance = Tax revenue – G – transfers
• BB > 0 then we have a surplus
• BB< 0 then we have a deficit
WHEN WE ADD FOREIGN TRADE
• People can save money both here or in other
countries…this is open to Americans and nonAmericans
• Capital Inflow (CI) can be positive or negative. If it
is positive, people are saving more in your country
vs saving it in other countries
• S + BB + CI = I
• CI> 0 more foreign funds coming in
• CI<0 fewer funds comings in than going out
FINANCIAL MARKETS
• Where regular people invest their current savings
and accumulated savings, or wealth,
• A financial asset is a paper claim that entitles the
buyer to future income from the seller
3 TASKS OF FINANCIAL SYSTEM
1. reducing transaction costs
1.
Eg: supermarkets make it so you can get all your groceries at
once… if a firm needs to make a big investment, rather than
borrowing from lots of individual people, banks do that for you so
firms only need one big loan
2. Reducing risk
1.
2.
You can buy a small share of a company…this gives the main owner
less risk and also each share holder minimal risk
Diversification: investing in several assets with unrelated, or
independent risks, allows a business owner to lower his/her total risk
of loss…also desired by individuals
3. Providing Liquidity
1.
2.
Liquidity is the ease by which you can convert an asset into cash
Financial system can provide various lines of liquid credit to make it
easier for business to have the liquidity of assets they need
TYPES OF ASSETS
1. Loans – a lending agreement between an
individual lender and an individual borrower
2. Bonds – the seller of a bond promises to pay a
fixed sum of interest each year and to repay the
principal to the owner upon a particular date
3. Loan-backed securities – assets created by
pooling individual loans and selling shares in that
pool (securitization)
4. Stocks – a share in the ownership of a company
FINANCIAL INTERMEDIARIES
• Financial intermediaries – an institution that transforms
funds gathered from many individuals into financial
assets.
1. Mutual Funds – a financial intermediary that creates a
stock portfolio by buying and holding shares in
companies and then selling shares of the stock
portfolio to individual investors
2. Pension Funds and Life Insurance Companies –
1.
2.
Pensions are nonprofit institutions that collect the savings of
their members and invest those funds in lots of assets,
providing their members with income when they retire
Life Insurance – sell policies which guarantee a payment to
the policy holder’s beneficiaries when the holder dies
3. Banks – a financial intermediary that provides liquid
financial assets in the form of deposits to lenders and
uses their funds to finance the illiquid investment
spending needs of borrowers
DAY 2: DEFINITION AND
MEASUREMENT OF MONEY;
THE TIME VALUE OF MONEY
Review
from
Friday:
pg 128
Learning Goals:
• Money is not the same as wealth. Money is essentially anything
that is easily exchangeable for goods and services.
• Many things have been used as money by different human
civilizations. All successful forms of money must serve as a medium
of exchange, a store of value, and a unit of account.
• Two aggregate measures of the money supply are defined by the
Federal Reserve and discussed at the principles level.
• M1, the narrowest definition, contains only currency in circulation (also
known as cash), traveler’s checks, and checkable bank deposits.
• M2 starts with M1 and adds several other kinds of assets, often referred to as
near-moneys—financial assets that aren’t directly usable as a medium of
exchange but can be readily converted into cash or checkable bank
deposits, such as savings accounts.
• Why a dollar today is worth more than a dollar a year from now.
• How the concept of present value can help you make decisions
when costs or benefits come in the future.
THE MEANING OF MONEY
• Money and wealth are often confused. This section of
the module provides a very easy way to separate money
from other assets that have value.
WHAT IS MONEY
• How and why would $20 in your pocket be different
from a laptop or a cell phone? Because only one
will be accepted as currency at your favorite store.
• Money is essentially anything that is easily
exchangeable for goods and services.
• Using money helps eliminate the need for barter.
ROLES OF MONEY
Complete pg 125
1.
2.
Medium of Exchange
• Your employer exchanges dollars for an hour of your labor and you exchange those
dollars for a grocer’s pound of apples. The grocer exchanges those dollars for an
orchard’s apple crop, and on and on.
• Without money, we would make such exchanges in a barter system.
• If I were a cheese maker and I wanted apples, I would need to find an orchard that also
needed cheese, and this would be a supremely difficult way to do my shopping. “Double
coincidence of wants.”
Store of Value
• So long as prices are not rapidly increasing, money is a decent way to store value. You
can put money under your mattress or in a checking account and it is still useful, with
essentially the same value, a week or a month later.
• If I were the town cheese maker, I must quickly find merchants with whom to exchange
my cheese, because if I wait too long, moldy cheese loses its value.
• Unit of Account
• Units of currency (dollars, euro, yen, etc) measure the relative worth of goods and
services just as inches and meters measure relative distance between two points. In the
barter system, all goods are measured in terms of other goods.
• Prices in a Barter Economy: A lb of cheese= dozen eggs = ½ lb of sausage = 3 pints of
ale…..
• With money, the value of cheese, and all other goods and services, is measured in terms
of a monetary unit like dollars.
TYPES OF MONEY
• Commodity money
• Something used as money, normally
gold or silver, that has intrinsic value in
other uses
• Commodity-backed money
• A medium of exchange with no
intrinsic value whose ultimate value
was guaranteed by a promise that it
could always be converted into
valuable goods on demand
• Fiat money
• Money whose value derives entirely
from its official status as a means of
exchange
MEASURING THE MONEY SUPPLY
Complete
pgs 126-127
How much money is there? It depends on what we define as money.
The Federal Reserve, our central bank, has two aggregate measures
of the money supply.
• First, we add up the money that is most easily used to make
transactions (the most liquid).
M1 = currency and coin in circulation + checking deposits + traveler’s checks
• Then, the Fed expands the definition to include “near monies” or
forms of money that can fairly easily be converted to cash (slightly
less liquid than M1). Near monies pay interest while few items in M1
pay interest.
M2 = M1 + savings accounts + short-term CDs + money market accounts
• Short-term CD – you agree to keep your money in that account for a fixed
amount of time (1 month – up to 1 year)
• Money Market Account – bank account with limited check writing abilities
(almost a hybrid of a savings and checking account)
CONCEPT OF PRESENT VALUE
• Suppose you could have $1000 today or $1000 next year?
Which would you choose?”
• $1000 today! Of course, but why?
• It would allow me the satisfaction of buying or saving today,
rather than waiting.
• For example, if I need to buy food or pay my rent, I can’t wait
a year to get my hands on that money.
• The other reason is that if you had the money today, you
could put it in the bank and in a year you would have more
than $1000.
• So for both reasons, $1000 today is worth more than waiting a
year to get $1000.
BORROWING, LENDING,
AND INTEREST
You are going to lend your friend $100, and he is going to pay you back in one year.
• Assume no inflation, you agree to a 10% interest rate, the going rate you could receive if you
had simply saved the money. Why do you need to receive interest on this loan?
• The opportunity cost of lending your friend $100 is the interest you could have earned, $10,
after a year had passed. So the interest rate measures the cost to you of forgoing the use of
that $100.
• Rather than saving it, you could have spent $100 on clothing right now that would have
provided immediate benefit to you.
• Repayment received on lending $100 for one year = $100 + $100*.10 = $100*(1+.10)
• What if you were going to lend your friend the money for two years?
• Repayment in two years = $100(1.10)*(1.10) = $121
• Generalization:
• Your friend, as a borrower, must pay you $21 to compensate you for the fact that he has your
$100 for a period of two years.
• You, as a saver, could put the $100 in the bank today, two years from now you would have
$121 to spend on goods and services.
• This implies that you would be completely indifferent between having $100 in your pocket
today or $121 two years from today.
• They are equivalent measures of purchasing power, just measured at two different points in
time, and it is the interest rate that equates the two.
DEFINING PRESENT VALUE
• There is a difference between dollars received today and dollars received in the future.
• To see the relationship between dollars today (present value PV) and dollars 1 year from
now (future value FV), a simple equation is applied:
Future Payment, or FV = PV*(1+r) or, using our example,
FV = $100*(1.10) = $110
• In other words, one year into the future, $100 in the present will be worth $110. This is true
whether you saved it or lent it to your friend.
• We can also rearrange our equation and solve for the present value PV:
PV = FV/(1+r)
• Using our example again, PV = $110/(1.10) = $100
• This tells us that $110 received a year from now is worth $100 in today’s dollars.
• Now let’s look again at the decision to lend the money for a period of t=2 years:
• Repayment in two years = $100(1.10)*(1.10) = $121
•
•
•
•
•
FV = PV(1+r)(1+r) = PV(1+r)t OR PV = FV/(1+r)t
Money today is more valuable than the same amount of money in the future.
The present value of $1 received one year from now is $1/(1+r).
The future value of $1 invested today is $1*(1+r).
Interest paid on savings and interest charged on borrowing is designed to equate the value
of dollars today with the value of future dollars.
FORMULA FOR FUTURE VALUE
FV = PV x
n
(1+r)
Number of
Periods (years)
Future Value
Present Value
Interest Rate
FORMULA FOR PRESENT VALUE
PV = FV /
n
(1+r)
Number
of
Periods
Present Value
Future Value
Interest Rate
(years
unless
otherwise
stated)
USING PRESENT VALUE
Complete
pgs 129131
• Decisions often involve dollars spent, or received, at different points in time. We can
use the concept of FV to evaluate whether we should commit to a project (or choose
between projects) today when benefits may not be enjoyed for several years.
• Example:
What if you could invest $10,000 now and receive a guaranteed (after inflation) $20,000
later? Good deal? Maybe.
What if you had to wait 10 years to receive your $20,000?
If I put my $10,000 in an alternative investment earning 8%:
Calculate the future value of $10,000 you would get today
Calculate the present value of $20,000 you would get 10 years from now?
When held to the same standard (time) which one is more valuable?
• FV = 10,000*(1.08)10 = $21,589.25
• PV = 20,000/(1.08)10 = $9263.87
• So you would only have to invest $9263.87 to get $20,000 in 10 years, rather than the
aforementioned $10,000.
BANKING AND MONEY CREATION
• Day 3 -Learning
Goals
• The role of banks in
the economy.
• The reasons for and
types of banking
regulation.
• How banks create
money.
MONETARY ROLE OF BANKS
• Recall the definition of M1 = currency + coin +
traveler’s checks + checking deposits
• This last component of M1 is where the role of banks
comes into focus. If a large part (about half) of the
money supply is accounted for by checking
deposits into banks, the banks must play a crucial
role in the supply of money in the economy.
WHAT BANKS DO
• Banks are financial intermediaries in business to earn profit, but in the
process they do make more money.
• Banks offer a safe place for depositors to put money and they offer
lending services to borrowers who need money. A saver is paid interest
on his or her savings, and a borrower is charged interest on his or her
borrowing. Another way of thinking about it is that banks take liquid
assets (savings) to finance the investment of illiquid assets (homes and
capital equipment).
• Banks only hold a fraction of their deposits in reserve. These reserves are
there for customers who wish to withdraw money from their checking and
saving accounts. Banks know that on any given day, only a small fraction
of reserves will be withdrawn, so the bank can lend the rest and profit
from making those loans. Once loans are made, there is now more
money in circulation, and the money supply increases.
• To see how banks can create money, introduce a simple tool for
analyzing a bank’s financial position: a T-account. A business’s T-account
summarizes its financial position by showing, in a single table, the
business’s assets and liabilities, with assets on the left and liabilities on the
right.
Assets
Liabilities
IF THIS WERE A ‘REGULAR BUSINESS’
• Suppose a small business, Jim’s Jerseys, produces
athletic uniforms. Jim owns $50,000 in equipment
and $10,000 in cloth. These are his assets because
he owns them. Jim has also borrowed $25,000 from
the bank and this is his liability, because he owes it
to someone else, the bank.
Assets
Liabilities
$50,000
$25,000
$10,000
WHAT HAPPENS WHEN THE BUSINESS
IS A BANK? THINGS SHIFT A BIT
• But this module is focused on banks, so let’s look at a
hypothetical bank’s T-account. Main Street Bank has $2
million in deposits. These are liabilities to the bank
because they are simply holding that money for
customers who could withdraw the money at any time.
The bank has $200,000 in cash reserves and has made
$2 million in loans to borrowers. The cash reserves and
the loans are assets for the bank.
What % is the
bank holding as
reserves?
This is the reserve
ratio and its
amount (%) is
controlled by the
Fed
Assets
Loans
Cash Reserves
Liabilities
$2,000,000
$200,000
Deposits
$2,000,000
THE PROBLEM OF BANK RUNS
• Depositors put their money in
banks to earn interest and to keep
it safe. But when the public begins
to fear that the bank itself might
fold, or if they fear for the stability
of the entire financial system, they
may want to withdraw their
money. If everyone goes to the
bank to withdraw their deposits, it
creates a bank run.
• The bank keeps only a small
percentage of the total deposits
on reserve, so a bank run can lead
to a self-fulfilling prophesy of the
bank’s failure. This can be very
damaging to communities and it
can spread across the economy.
This is one of the primary reasons
for regulating banks.
BANK REGULATION
Learning from the disastrous bank runs of the 1930s, the U.S.
has put in place several important regulations to insure the
public trust in banks and to lessen the probability of rampant
failures.
1.
Deposit insurance – the US gov. created the FDIC to
provide deposit insurance that will be paid even if bank
can’t come up with funds…today $250,000 per account
2.
Capital requirements - To reduce incentive for excessive
risk-taking, regulations require that the owners of banks
hold substantially more assets than the value of bank
deposits. This way, the bank will still have assets larger
than its deposits even if some of its loans go bad
3.
Reserve Requirements – the Fed establishes the required
reserve ratio for banks. This policy insures that the banks
will have a certain fraction of all deposits on hand in the
event that customers wish to withdraw money. In the US,
the required reserve ratio for checkable bank deposits is
usually 10%
4.
The Discount Window – the Fed stands ready to lend
money to banks via an arrangement known as the
Discount Window. We will look in another lesson about
how the interest rate that the Fed charges on these
loans, the discount rate, is one of the tools of monetary
policy. This helps if a bank finds itself in a short-term
pinch because of many depositors withdrawing cash in
a short period of time.
DETERMINING THE MONEY SUPPLY
Reminder: Most basic money supply is…
M1 = currency + checking deposits (travelers checks aren’t even really a thing anymore)
Eli has $5,000 in cash and
decides he wants to open an
account at Main Street Bank.
Assets
Liabilities
Loans no change
Checking Deposits
Cash Reserves
+$5,000
+$5,000
Here, money has NOT been
created; Eli just moved his money
from cash to checking, so M1 is not
affected
STEP 2 OF MONEY CREATION
• Main Street Bank MUST keep 10% ($500) of Eli’s
deposit in reserve, and makes $4,500 loan to Max so
he can buy some furniture at Melanie’s Mega Mart.
• The loan to Max has the following affect on the TAccount at Main Street Bank
Assets
Liabilities
Loans
+$4,500 Checking Deposits No change
Cash Reserves
-$4,500
STEP 3
• Melanie banks at the First Bank of Sherman, so when
she receives $4500 from Max for the furniture, she
deposits the money at FBS. The affect on the Taccount at FBS is shown below
Assets
Loans
Liabilities
No Change Checking Deposits +$4500
Cash Reserves +$4500
STEP 4
• The FBS must also keep 10% ($450) of Melanie’s deposit
in reserve, and can then make a $4050 loan to someone
Jason…
• Summary of the steps:
• Eli deposited $5000
• Max borrowed $4500 for furniture
• Melanie got paid for furniture and deposited $4500 at another
bank
• Melanie’s bank loans $4050 to Jason
So an initial deposit of $4500 created new M1 of $4500
and $4050 = $8550 after only two loans and this would
continue
RESERVES, BANK DEPOSITS AND THE
MONEY MULTIPLIER
• The key to this multiplication of money
is that the bank holds 10% of cash in
reserve and lends the remaining 90%.
This 90% refers to excess reserves
• Excess reserves = total reserves –
required reserves (aka what the bank
may legally loan out)
• In the previous example, the creation
of M1 began with the $4500 loan to
Max. We also know that the money
multiplier is
• MM = 1/Reserve Ratio (which would be
similar to the MPS)
• So in our example:
• 1/.1= 10 and 10 * 4500 = $45000 of newly
created M1
• (the initilal $5000 does not get counted as
new money)
THE MONEY MARKET IN REALITY
• What if Max had not spent his entire $4500 at the
Mega Mart? Or what if the bank decided to keep
20% of Eli’s deposit in reserve and only lend $4100 to
Max?
• These would have slowed down the money
multiplier process and less than $45000 of new M1
would have been created
Activity Packet Pgs 133-136
DAY 4: MONETARY POLICY AND THE
MONEY MARKET
• Again, this should be
more of a review now

Learning Goals:
• Function of the Fed
• Major tools of the Fed
• What the money
demand curve is
• Why the liquidity
preference model
determines the
interest rates in the
short run
MONETARY POLICY
• To back up, Monetary Policy is a tool used by the
federal reserve to prevent or address extreme
macroeconomic fluctuations in the US economy
• Other roles of the Fed:
• Provide Financial Services to the 12 regional Federal
Reserve banks
• Supervise and regulate banking institutions
• Maintain the stability of the financial system
3 TOOLS OF MONETARY POLICY
1. Reserve Requirement –
Banks must maintain a 10% required reserve
ratio on average over a 2 weeks period. If
not, they face penalties
If a bank seems to have insufficient funds,
the bank can borrow additional reserves
from other banks via the federal funds
market (a financial market that allows banks
that fall short of the reserve requirement to
borrow reserves, typically just overnight, from
banks that are holding excess reserves)
The Federal Funds Rate – the interest rate at
which funds are borrowed and lent in the
federal funds market. This plays a key role in
monetary policy (also, because borrowing
funds to cover required reserves cost money,
it discourages banks to get in this situation)
To impact money supply, the Fed can
change the required reserve ratio. However,
today, this rarely happens. The last time this
was done was in 1992
3 TOOLS OF MONETARY POLICY
2. The Discount Rate
Banks in need of reserves could borrow from
the Federal Reserve itself through the
discount window. The Discount Rate is the
rate of interest the Fed charges on those
loans. Normally, the discount rate is set 1%
above the federal funds rate in order to
discourage banks from turning to the Fed
when they are in need of reserve. This is
known as the “spread”
The discount rate can also impact money
supply – if the fed decreases the discount
rate, it encourages more lending and
therefore money grows.
The Fed doesn’t normally use the discount
rate to control money supply. The Fed
typically sets the discount rate at a certain
gap above the federal funds rate. As the
federal funds rate moves, the discount rate is
adjusted to maintain the gap.
3 TOOLS OF MONETARY POLICY
3. Open Market operations
In an open market operation,
the Federal Reserve buys or
sells US Treasury Bills, normal
through a transaction with
commercial banks (banks
that mainly make business
loans, as opposed to home
loans).
This is used to change money
supply because if the US buys
from a bank, it gives the
bank cash, which it can then
use to make more loans…or
vice versa
Pg 143 – 152 in activity packet
show tons of different ways
monetary policy is
practiced…short and long run
and each of the 3 tools
REVISITING THE MONEY MARKET
Think of the Demand
for Money as demand
for M1. earned
interest is forgone,
thus the short-term
interest rate is the
opportunity cost for
holding money
OPPORTUNITY COST OF HOLDING
MONEY
As the interest rate
increases, the
opportunity cost for
holding money also
increases, therefore,
people want less
money- Quantity of
money demanded
will fall
Also, if you want to think of
this graph in terms of time,
think of it as short term. We
assume that in a short
period of time there will be
no inflation, so the nominal
interest rate is equal to the
real interest rate
SHIFTERS OF THE MONEY DEMAND
CURVE
Note: If any external change makes holding money in your pocket more
desirable at any interest rate, the demand curve shifts to the right
1.
2.
3.
4.
Changes in Aggregate Price Level –
• Higher prices increase the demand for many (curve right) and lower prices reduce
the demand for money. Specifically, the demand for money is proportional to the
price level. If aggregate price level rises by 20% the quantity of money demanded
at any interest rate also increases by 20%. Why? Because you need 20% more
money to buy the same market basket
Changes in Real GDP
• As the economy gets stronger, real incomes and real GDP rise. The larger the
quantity of goods and services we can buy, the larger the quantity of money we will
want to hold at any interest rate. So an increase in real GDP shifts money demand
curve right
Changes in Technology
• Generally, advances in information technology have tended to reduce the
demand for money by making it easier for the public to make purchases without
holding significant sums of money. If there was an ATM on every corner and in ever
store, there would be little need to hold money in your pocket.
Changes in Institutions
• Regulations that make it more attractive to keep money in banks will reduce the
demand for money. If a nation’s political and banking system became unstable, it
might increase the demand for money because people would rather hold it than
store it in an institution that is falling apart.
MONEY AND INTEREST RATES
• The Fed uses the three tools of monetary policy to
achieve a target level for the federal funds rate
(interest rate at which funds are borrowed and lent
in the federal funds market)
• Most interest rates in the country (auto loans, home
loans, etc) move closely alongside the Federal
Funds Rate. So by influencing the federal funds rate,
the Fed has a huge impact.
EQUILIBRIUM INTEREST RATE
• We assume that
the money supply,
MS, determined by
the Fed is fixed at
any given point in
time. It is also
independent of
the interest rate so
it is a vertical line.
This point
represents the
liquidity
preference. This
model says that
the interest rate
is determined by
the supply and
demand for
money in the
money market.
EXAMPLE:
1. Quantity of money
supplied exceeds
the quantity of
money
demanded.
2. Quantity of money
demanded
exceeds the
quantity of money
supplied
1. What would happen to interest rates and the quantity of
money demanded if there was some interest rate i1 that
was greater than i*
2. What would happen to interest rates and the quantity of
money demanded if there ewas some interest rate i2 that
was less than i*
TWO MODELS OF THE INTEREST RATE
• The idea of the liquidity preference describes
equilibrium in the money market. This model is a
good foundation for learning a similar style of
market in loanable funds that also shows how low
interest rates are determined and the impact of
monetary policy.
• We will discuss this next class.
Activity packet pgs
139-142 (some just
reading if you need to
revisit)
REST OF THE WEEK
• Thursday:
• You MUST finish your Phillips curve packet so we can talk
about it!!!!!
• Loanable Funds lecture/graph/activity packet
• A couple of Practice FRQs in class
• Friday:
• Short Schedule! Makes for a SHORT TEST!
• Maybe 15-ish MC and 2-ish FRQs (we have a 40 min class
due to spring sports assembly)
LOANABLE FUNDS MARKET
Learning Goals:
• How the loanable
funds market matches
savers and investors.
• The determinants of
supply and demand in
the loanable funds
market.
• How the two models of
interest rates can be
reconciled.
DON’T WORRY!! This is your last real
graph this semester.
THE MARKET FOR LOANABLE FUNDS
• Closed economy: Savings = Investment
• S=I
• Add the public sector (government):
• National savings = private savings + public savings = I
• Add the foreign sector:
• National savings + capital inflow = I
• It is through the financial markets by which the funds of the
savers are borrowed by investors.
• Economists use the model of a market for loanable funds
to explain these interactions and determine the
equilibrium real interest rate.
THE EQUILIBRIUM INTEREST RATE
• 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 REAL
interest rate, denoted by r.
• 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 rate = nominal
rate.
• But it’s also true that if expected inflation is constant,
any change in the nominal rate will be reflected in an
identical change in the real rate.
• This is why the graphs are sometimes labeled
“nominal interest rate for a given expected future
inflation rate.”
• Note: for the reasons explained above, it is important,
and accurate, to get in the habit of labeling this
vertical axis as “real interest rate”
See pgs
157-159
Remember:
Real =prices that
account for
inflation
Nominal = prices in
that year
THE DEMAND FOR LOANABLE FUNDS
• The Demand for Loanable Funds
comes from borrowers.
• Demand is downward sloping
for one very intuitive reason.
• 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 be
profitable, and the funds will be
demanded.
• Rate of return (%) =
100*(Revenue from project –
Cost of project)/(Cost of
project)
• As the real rate falls, more
projects become profitable, so
the quantity of funds
demanded will increase.
SUPPLY FOR LOANABLE FUNDS
• The 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 real interest rate rises,
the opportunity to earn more
income rises, so more dollars will
be saved.
• As the real rate rises, the quantity
of funds supplied will increase.
EQUILIBRIUM FOR LOANABLE FUNDS
• Here, the equilibrium interest rate is r*%, at which Q* dollars are
lent and borrowed. Investment spending projects with a rate
of return of r*% or more are funded; projects with a rate of
return of less than r*% are not. Correspondingly, only lenders
who are willing to accept an interest rate of r*% or less will
have their offers to lend funds accepted.
SHIFTS OF DEMAND FOR LOANABLE
FUNDS
The factors that can cause the demand
curve for loanable funds to shift include the
following:
1.
Changes in perceived business
opportunities:
•
•
•
2.
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 ripe with
profitable investment opportunities, the
demand for loanable funds will increase.
If firms believe the economy is poised for a
recession where profitable investment
opportunities will be few and far between,
the demand will decrease.
Changes in the government’s
borrowing:
•
•
•
Governments that run budget deficits are
major sources of the demand for loanable
funds.
When the government runs a budget
deficit, the Treasury must borrow funds and
acquire more debt. This increases the
demand for loanable funds in the market.
If the government were to run a budget
surplus, less debt would be required and the
demand for loanable funds would
decrease.
SHIFTS IN SUPPLY OF LOANABLE
FUNDS
Among the factors that can cause
the supply of loanable funds to shift
are the following:
1. Changes in private savings
behavior:
• If households decide to consume
more and save less, the supply of
loanable funds will shift to the left.
2. Changes in capital inflows:
• For a variety of economic and
political reasons, a nation may
receive more capital inflow in a given
year.
• 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.
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.
• We have seen in previous modules that unexpected inflation
creates winners and losers, particularly among borrowers and
lenders.
• Economists capture the effect of inflation on borrowers and
lenders by distinguishing between the nominal interest rate
and the real interest rate, where the difference is as follows:
• 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 EFFECT
After the American economist Irving Fisher, who proposed
it in 1930): the expected real interest rate is unaffected by
the change in expected future inflation.
• The Fisher effect says that an increase in expected future
inflation drives up nominal interest rates, where each
additional percentage point of expected future inflation
drives up the nominal interest rate by 1 percentage
point.
• The central point is that 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 loanable funds or the
expected real interest rate; all it affects is the equilibrium
nominal interest rate.
RECONCILING THE TWO INTEREST
RATE MODELS
• You have already seen the money market that
illustrates the liquidity preference model. The short
term interest rates are determined at the
intersection of money demand and money supply.
• In the loanable funds model, we see that the
interest rate matches the quantity of loanable funds
supplied by savers with the quantity of loanable
funds demanded for investment spending.
• Let’s try to make sense of this.
Pgs 139-142
PRACTICE FRQ 2010 #2
• Answers: https://www.youtube.com/watch?v=n3INFfrqQg&list=PL1oDmcs0xTD9tWXi_jm2Q4SF1ULktz-k&index=9
PRACTICE FRQ – 2012 #1
• Answer:
https://www.youtube.com/watch?v=fBKaWhM9oNw&in
dex=13&list=PL1oDmcs0xTD9tWXi_jm2Q4-SF1ULktz-k
PHILLIPS CURVE (REVIEW) ANSWERS
FROM TEST (2013 #3; 2011 B#1)
#2
OUR PARTS E AND F WERE
DIFFERENT/ELIMINATED AS WE
HADN’T COVERED THE UNITS YET