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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 people who have extra income they want to save and lend out. • The DEMAND for loanable funds comes from households and firms that wish to borrow to make investments. 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 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 deficits Copyright © 2004 South-Western Policy 1: Saving DISincentives • Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. Copyright © 2004 South-Western Policy 1: Saving Incentives • A tax decrease increases the incentive for households to save at any given interest rate. • The supply of loanable funds curve shifts to the right. • The equilibrium interest rate decreases. • The quantity demanded for loanable funds increases. • 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: Investment Incentives • An investment tax credit increases the incentive to borrow. • Increases the demand for loanable funds. • Shifts the demand curve to the right. • Results in a higher interest rate and a greater quantity saved. • If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. 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 Deficits • A budget deficit increases the demand for loanable funds. • Shifts the demand curve to the right. • Increases the equilibrium interest rate. • Reduces the equilibrium quantity of 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 4: Government Budget Surpluses • A budget surplus increases the supply of loanable funds: • Shifts the supply curve to the right • Decreases the equilibrium interest rate. • Increases the equilibrium quantity 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