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Investment
Introduction to the Loanable Funds Market
Investment
• Investment (I) is a volatile component of GDP
– Changes with level of interest rates
• Investment has 3 subcomponents:
– New capital expenditure by firms
– New housing expenditure by households
– Net inventories
Investment
Investment is fixed
At a given level of interest rate
Includes:
Firm builds new plants
Orders more machines/supplies
Raises/lowers inventories
Interest
Rate
Autonomous Investment
Id
$ Investment
GDP
Deriving Savings
• GDP is both total income & total expenditure:
Y = C + I + G + NX
• Assume a closed economy – (does not engage in foreign trade)
Y=C+I+G
• Subtract C & G from both sides:
Y–C–G=I
Derived Savings continued..
• New Equation:
Y–C–G=I
{---------------}
• This equals total income after paying for C & G
• Y – C – G is known as Savings (S)
– the equation can be written as:
(what you don’t spend, you save)
S=I
• For the economy as a whole, savings must equal investment:
Savings = Investment
National, Private & Public
• National Saving
– Income that remains after paying for C + G
– Equals Y – C – G
• Private Saving
– Income that households have left after taxes & consumption
– Equals Y – T – C (T=Taxes)
– Public Saving
– Amount of tax revenue government has left after spending
– Equals
T – G (T=Taxes)
LOANABLE FUNDS
• Financial markets coordinate the economy’s saving &
investment in the market for loanable funds
• Supply of loanable funds:
– Sum of private & public savings
• Demand for loanable funds:
– households or firms that wish to invest
Loanable Funds
Real
Supply
Interest
Rate
Sum of Public
& Private
Savings
5%
Demand
Investment
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
Real Interest Rate
• The price of the loan in real terms (r)
– amount borrowers pay for loans & lenders receive on savings
• If real return on investment is > r, then make investment
Government Policies
• Gov’t Policies greatly affect Saving & Investment
• Gov’t Incentives:
– Taxes on savings
– Taxes on investment
• Size of Gov’t budget deficits or surplus
Example:
Saving Incentives
• A tax decrease on savings
• Result: increases the incentive for households to save
at any given interest rate
– Supply of loanable funds curve shifts right
– Equilibrium interest rate decreases
– Quantity demanded for loanable funds increases
Changing Saving Incentives
Real
Interest
Rate
Supply, S1
S2
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
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Example:
Investing Incentives
• A tax credit on investing
– will increase the incentive to invest:
Real
Interest
Rate
------------------------------- E1
------------------------------
i1
S1
Demand Increases
Interest Rates rise
Q1
D1
D2
Qty
Loanable Funds
Worksheet