Download interest rates

+
Money & Loanable Funds
Markets
C-4 Students will pose recommendations for
the FED to enact in the face of a recessionary
period of economic performance
+
Meanwhile, in Russia…
Russia’s Central Bank increased interest rates from
10.5% to 17% yesterday…why? How?
+
First and Foremost…

Interest rates move together, short term or long term, if the key interest
rate (federal funds rate) increases, so do ALL other interest rates, and
vice versa

Interests rates in an economy = the “price” of money in an economy

Money Market illustrates NOMINAL interest rates vs quantity of $ in the
short run

Loanable Funds Market illustrates REAL interest rates vs quantity of
loanable funds in the long run

We are examining how the FED will manipulate M1 in the US’s economy
and how these manipulations of the money supply will affect interest
rates (which are all the same) and ultimately GDP…we’ll get there
+

Money Market (Liquidity
Preference Model of Int. Rts.)
MD = downward sloping

Opportunity cost of holding
money in an economy


MS = vertical line


 N. Int. Rts =  opportunity
cost; quantity of money
demanded 
NOMINAL!!!
..
O
ie
E
FED directly controls the
quantity of money in an
economy; only be “x” amount
of M1 at a time
E = intersection of MS and
MD identifies interest rates in
economy
.
L
Q
*If our economy is ever at disequilibrium in
the money market, natural forces will work
to move it back to ie
+

Right denotes an increase in the
quantity of money demanded at all
interest rates and vice versa
Change in Aggregate Price Level:
if goods/services in an economy
cost more, people need to hold
more money ( MD )
1.

2.

Shifts in Money Demand Curve
Opposite is also true
Change in Real GDP: if economy
produces more goods/services
(increase in GDP) households
need to hold more money to be
able to buy ( MD )*
Change in Technology: ATMs, credit
and debit cards have made holding
cash less important ( MD )
IN
MS
i2
i1
i3
MD3
MD1
Q
Rule:
 MD =  Int. Rts.
 MD =  Int. Rts
MD2
+
Loanable Funds Market

Bringing savers (loan issuers/lenders) and borrowers (firms)
together

Using REAL interest rates on our Y-axis—real interest drives
investment spending, not nominal interest
• LF Demand (Investment) =
at  Int. Rts quantity of loans
demanded by firms 
• LF Supply (Savings) =  Int.
Rts quantity of loans
supplied 
• LF Equilibrium = quantity of
loans demanded equals
quantity of loans supplied
@ Re
Or, the quantity of loans
savers want to lend is equal to
the quantity of funds firms
want to borrow
Re
.
Qe
E
+
Shifts of the LF Demand Curve
(Investment)
1.
Change in perceived business opportunities: if a firm
thinks the rate of return on investment spending will
change, there may be an increase or decrease in desired
investment (demand for loans) at all interest rates
Ex: Internet expansion in 1990s
2.
Changes in Gov’t Borrowing: If a gov’t runs a deficit and
must finance additional spending with borrowed funds
(loans) desired investment will increase at all interest rates
Ex: US gov’t in 2003 paid off a lump sum of debt valued at
$416 B…money was borrowed from savers (US and foreign)
***Remember: when Int. rts rise there will be a decrease in
economic growth (crowding out)
+
Shifts of the LF Supply Curve
(Savings)
1.
Changes in private savings behavior: if people are
spending more money, for whatever reason, we assume
they are saving less ( LF Supply). If people spend less
and save more, like in a recession ( LF Supply). Think
wealth effect!
2.
Changes in capital inflows: if a nation experiences a period
of greater foreign investment, like the US in recent history
prior to 2008 ( LF Supply). If a nation experiences a
period of great capital outflows, perhaps during an
economic collapse ( LF Supply)
***Remember: Investment = savings!
When people have more money to save, they deposit more
money in banks, banks can then loan more funds…
+

2 Models Come Together: Interest
Rates in the Short Run
Money market drives changes in the interest rate that the
loanable funds market mirrors
1.
Assume FED increases MS(MS =  Int. Rts)
2.
Fall in interest rates in money market leads to an  GDP (
Investment). This  GDP =  savings (multiplier theory tells us
that with this increase in income, more money will be spent and
more will be save than prior to the  GDP).
3.
 savings =  supply of loanable funds (LF Supply = savings).
This  savings results in a  in Int. Rts
***This change in interest rates in BOTH models is the exact
same!!! The interest rates are directly proportional to one another!
+
2 Models Come Together: Interest
Rates in the Short Run
+
2 Models Come Together: Interest
Rates in the Long Run

In long run changes in the money market will not affect
interest rates!

In the long run, an  in MS will  Int. Rts; however in long
run, aggregate price level will rise proportionally with the
decrease in interest rates. When aggregate price level rises,
people need to hold more money to purchase
goods/services, increasing demand for money.

Rightward shift of MS and MD will lead us to the same interest rate
we began with in the money market
+
2 Models Come Together: Interest
Rates in the Long Run

In the loanable funds market:
1.
The increase in MS reduces interest rates and increases Real
GDP.
2.
In long run, just like with our classical theory on AD/AS, Real
GDP will fall back to pre-MS shift levels from increase in wages
and other input costs (back to LREQ)
3.
Ultimately, in our market for loanable funds, we arrive back at
our initial equilibrium level of interest rates and equilibrium
quantity of loanable funds
+
2 Models Come Together: Interest
Rates in the Long Run
+
So, what about Russia?


How did their Central Bank increase their equivalent to our
“federal funds rate” to 17%?

In the SR, how does this affect interest rates in the loanable funds
market?

In the LR, how does this affect interest rates in the loanable funds
market?
For tomorrow: how does the FED expand or contract MS?

How do changes in MS affect the investment demand curve?