Download Loanable Funds

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.
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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
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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
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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???
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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.
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The Market for Loanable Funds
Real
Interest
Rate
Supply
RIR
%
Demand
0
Q
Loanable Funds
(in billions of dollars)
QLF
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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The Loanable Funds Graph
• Worksheet Practice
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Mods
Inflation-Related
Topics
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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
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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
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Demand-Pull Inflation
• More demand for goods than
there are goods available
• Occurs because of
• Lack of goods available
• Econ expansion
• Political Motivations
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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
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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
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Disinflation
• Disinflation refers to the actions to try to reduce
inflation
• Disinflation is difficult
• AD/AS graph
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Deflation
•
•
•
•
•
Definition
Debt Deflation
Effects of Expected Deflation
Zero Bound
Liquidity Trap
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Worksheet Practice
• Fisher effect
• Types of Inflation
• Monetary Equation
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