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The Loanable Funds Market Copyright © 2004 South-Western Mod 29 Two Models of the Interest Rate Liquidity Preference Model Loanable Funds Market Copyright © 2004 South-Western THE MARKET FOR LOANABLE FUNDS • The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. • Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. • Financial markets coordinate the economy’s saving and investment in the market for loanable funds. Copyright © 2004 South-Western Supply and Demand for Loanable Funds The SUPPLY of loanable funds comes from players in the economy who have extra income they want to save and lend out. •Sources for LF = household savings, national savings (Gov’t surpluses) & Capital Inflows The DEMAND for loanable funds comes from players in the economy that wish to borrow to make investments. •Demanders for LF = businesses, households, government Copyright © 2004 South-Western Supply and Demand for Loanable Funds • The interest rate is the “PRICE” of a loan. • It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. • The interest rate in the market for loanable funds is the real interest rate. • The equilibrium of the supply and demand for loanable funds determines the real interest rate Copyright © 2004 South-Western Why/when we use NIR vs RIR • NIR (Nominal Interest Rate) used on Money Market Graph y axis • RIR (Real Interest Rate) used on Loanable Funds Graph y axis WHY??? Copyright © 2004 South-Western Interest Rates ctd We use NIR—nominal interest rate—in Money Market graph. This corresponds to Federal Funds rate, which is the interest rate used by Banks for overnight loans from other Banks. Since it's overnight, there is not room for inflationary effects. Therefore = nominal. We use RIR—real interest rate—on the Loanable Funds graph. RIR represents consumers, businesses, gov't getting involved with loans and savings. Since these loans and savings can be for a period of years, inflation can have an effect on the interest rate. Therefore = real. Copyright © 2004 South-Western The Market for Loanable Funds Real Interest Rate Supply RIR % Demand 0 Q Loanable Funds (in billions of dollars) QLF Copyright©2004 South-Western Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment 1. Taxes and saving 2. Taxes and investment 3. Government budget actions Copyright © 2004 South-Western Policy 1: National Savings Policies Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. If a change in tax law discourages saving, the result will be higher interest rates and less investment. Copyright © 2004 South-Western Policy 1: National Savings Policies A savings interest tax allowance increases the incentive for households to save at any given interest rate. If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. Copyright © 2004 South-Western An Increase in the Supply of Loanable Funds Interest Rate Supply, S1 S2 1. Tax incentives for saving increase the supply of loanable funds . . . 5% 4% 2. . . . which reduces the equilibrium interest rate . . . Demand 0 $1,200 $1,600 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. Copyright©2004 South-Western Policy 2: National Investment Policies An investment tax credit increases the incentive for businesses to borrow = greater demand for LF. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. Copyright © 2004 South-Western Policy 2: National Investment Policies A increase in investment tax decreases the incentive for business to borrow= less demand for LF If a change in tax law discourages investments borrowing by business, the result will be lower interest rates and less investment. Copyright © 2004 South-Western An Increase in the Demand for Loanable Funds Interest Rate Supply 1. An investment tax credit increases the demand for loanable funds . . . 6% 5% 2. . . . which raises the equilibrium interest rate . . . 0 D2 Demand, D1 $1,200 $1,400 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. Copyright©2004 South-Western Policy 3: Government Budget Actions *****A budget deficit increases the demand for loanable funds. The deficit borrowing crowds out private borrowers who are trying to finance investments. Copyright © 2004 South-Western The Effect of a Government Budget Deficit Interest Rate Supply 1.Government borrowing increases the demand for loanable funds . . . 6% 5% 2. . . . which raises the equilibrium interest rate . . . 0 D2 Demand, D1 $1,200 $1,400 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. Copyright © 2004South-Western South-Western Copyright©2004 Policy 3 : Government Budget Actions ****A budget surplus increases the supply of loanable funds: When government increases national saving by running a surplus, the interest rate falls and investment rises. Copyright © 2004 South-Western The Effect of a Government Budget Surplus Interest Rate Supply, S1 S2 1. A budget surplus iincreaser the supply of loanable funds . . . 5% 4% 2. . . . which reduces the equilibrium interest rate . . . Demand 0 $1,200 $1,600 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. Copyright©2004 South-Western A Summary of Shifts of Supply or Demand for Loanable Funds • Shifts of Supply: • Changes in Savings Behavior • Changes in Capital Inflows • Shifts of Demand • Changes in Business Opportunities for investment • Changes in Government Borrowing Copyright © 2004 South-Western The Loanable Funds Graph • Worksheet Practice Copyright © 2004 South-Western Mods Inflation-Related Topics Copyright © 2004 South-Western 29 & 33 Inflation and Interest Rates •The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. •According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. •The real interest rate stays the same. •Real Interest = Nominal Interest - Inflation Copyright © 2004 South-Western Nominal Interest Rate and the Inflation Rate Percent (per year) 15 12 Nominal interest rate 9 6 Inflation 3 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western Copyright © 2004 South-Western Types & Issues with Inflation • Demand-pull Inflation • Cost-push Inflation • Monetary Inflation • Changes to the money supply (The Fed) • Disinflation • Deflation Copyright © 2004 South-Western Demand-Pull Inflation • More demand for goods than there are goods available • Occurs because of • Lack of goods available • Econ expansion • Political Motivations Copyright © 2004 South-Western Cost-Push Inflation • Higher input costs in production drive up prices • Can occur because of: • Increased costs overall of Land, Labor, Capital • Increased costs due to Gov’t Regulations • Supply shocks Copyright © 2004 South-Western Monetary Inflation and the Quantity Equation • This is Inflation due to amount of Money Supply • Can be due to Fed Actions The Quantity Equation relates the quantity of money (M) and the velocity of transactions to the nominal value of output • MxV≡YxP M = quantity of money V = velocity Y = the quantity of output P = the price level Copyright © 2004 South-Western Disinflation • Disinflation refers to the actions to try to reduce inflation • Disinflation is difficult • AD/AS graph Copyright © 2004 South-Western Deflation • • • • • Definition Debt Deflation Effects of Expected Deflation Zero Bound Liquidity Trap Copyright © 2004 South-Western Worksheet Practice • Fisher effect • Types of Inflation • Monetary Equation Copyright © 2004 South-Western