Download Loanable Funds Theory

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Chapter 6:
Learning Objectives

Interest Rate Level Determination:



Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes
Applications:



Fisher effect
interest rates over the business cycle
the impact of a tight monetary policy
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A Selection of Yields over Time
20
Percent per year
16
Corporate
paper rate
12
Long-term
Canada bond
yield
8
4
Treasury bill
rate
0
60
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65
70
75
80
Year
85
90
95
00
Loanable Funds Theory

The loanable funds market is a
hypothetical market:


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Brings savers and borrowers together
Bring together the money available in
commercial banks and lending institutions
available for firms and households to finance
expenditures, either investments or
consumption
Loanable funds are often used to invest
in new capital goods
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Loanable Funds Theory


Explore the causes of increasing and
falling interest rate
Interest rate is the price of the loan

Represents the amount that borrowers pay
for loans and the amount that lenders
receive on their savings
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Loanable Funds Theory

Focus is on the Market for bonds
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Loanable Funds Theory


Focus is on the Market for bonds
Bond demand (Bd) is determined by investors’
preferences
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Loanable Funds Theory


Focus is on the Market for bonds
Bond demand (Bd) is determined by investors’
preferences

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Borrowers demand loanable funds
Ex: When an institution (a firm or government)
sells a bond, it is demanding loanable funds
Bond supply (Bs) is determined by borrowers’
preferences


Savers supply the loanable funds
Ex: Buying bonds will transfer their money to the
institution that issuing the bond (a firm or
government)
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Loanable Funds Theory


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
Focus is on the Market for bonds
Bond demand (Bd) is determined by investors’
preferences
Bond supply (Bs) is determined by borrowers’
preferences
For discussion purposes, ASSUME a one-year
discount bond

 $PD is inversely related to R (=[$FV-$PD]/$PD
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Loanable Funds Theory




Focus is on the Market for bonds
Bond demand (Bd) is determined by investors’
preferences
Bond supply (Bs) is determined by borrowers’
preferences
For discussion purposes, ASSUME a one-year discount
bond


 $PD is inversely related to R (=[$FV-$PD]/$PD)
The interaction between Bond demand and supply
determines the equilibrium interest rate
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Demand for Loanable Funds

Demand for funds come from
households and businesses who wish to
borrow to make investments


Mortgages, new equipments, factories
Higher interest makes borrowing more
expensive  quantity of loanable funds
demanded falls (as interest rate
increases)
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Supply of Loanable Funds

Supply comes from those who have
extra money to save or lend out


Buying bonds directly
Higher interest rate makes saving more
attractive
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From Bond demand/supply to Loanable funds
demand/supply
BOND DEMAND=SUPPLY OF
LOANABLE FUNDS
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From Bond demand/supply to Loanable funds
demand/supply
BOND DEMAND=SUPPLY OF
LOANABLE FUNDS
BOND SUPPLY=DEMAND FOR
LOANABLE FUNDS
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Figure 6.4. Market Equilibrium
Nominal interest rate
LFs
R1
C
•
R*
R0
Excess supply
D
•
•E
•
A
Excess demand
•
B
B*
Quantity of bonds
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LFd
Shifts in Loanable Funds demand/supply


Wealth (+ve)
SUPPLY SIDE
INFLUENCES
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
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply



Wealth (+ve)
Relative returns
(+ve)
SUPPLY SIDE
INFLUENCES
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
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply




Wealth (+ve)
Relative returns (+ve)
Relative riskiness (-ve)
SUPPLY SIDE
INFLUENCES
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
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply

Wealth (+ve)

Relative returns (+ve)

Relative riskiness (-ve)

Liquidity (+ve)

SUPPLY SIDE
INFLUENCES
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
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply






Wealth (+ve)
Relative returns (+ve)
Relative riskiness (-ve)
Liquidity (+ve)
Expected inflation (-ve)
SUPPLY SIDE
INFLUENCES
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
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply






Wealth (+ve)
Relative returns (+ve)
Relative riskiness (-ve)
Liquidity (+ve)
Expected inflation (-ve)
SUPPLY SIDE
INFLUENCES
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

Expected returns (+ve)
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply






Wealth (+ve)
Relative returns (+ve)
Relative riskiness (-ve)
Liquidity (+ve)
Expected inflation (-ve)
SUPPLY SIDE
INFLUENCES
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


Expected returns (+ve)
Govt policies (?)
DEMAND SIDE
INFLUENCES
Shifts in Loanable Funds demand/supply
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Wealth (+ve)
Relative returns (+ve)
Relative riskiness (-ve)
Liquidity (+ve)
Expected inflation (-ve)





SUPPLY SIDE
INFLUENCES
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Expected returns (+ve)
Govt policies (?)
Expected Inflation (+ve)
DEMAND SIDE
INFLUENCES
Nominal interest rate
Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds
A. A Demand Shift
R1
R2
•
•
B
A
•
LFd
B2
B1
Quantity of bonds
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2
LFd1

Changes in the rate of return on
investments, expected inflation, and
government policies shift the demand
for loanable funds
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Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds
B. A Supply Shift
Nominal interest rate
LFs2
R1
•
•
B2
B1
Quantity of bonds
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LFs1

Changes in wealth, relative returns,
relative riskiness, and liquidity cause
shift in the supply of loanable funds
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Two Applications

The Fisher Effect: how inflation
expectations affect nominal interest
rates  distinction between nominal
and real interest rates (Recall:
R=p+∏e)Figure 6.6
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Two Applications


The Fisher Effect: how inflation
expectations affect nominal interest
rates  distinction between nominal
and real interest rates (Recall:
R=+e)Figure 6.6
The business cycle and interest rates:
how changes in economic activity affect
nominal interest ratesFigure 6.8
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Nominal interest rate
Figure 6.6. The Fisher Effect
R*1=*0+ 1e
• E’
R*0= *0
+e0
• E
B*
Quantity of bonds
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LFs1
LFs0
LFd0
LFd1
Figure 6.8. Interest Rates in an Expansion
Nominal interest rate
LFs0 LFs1
R*1
R*0
• E’
•E
LFd1
LFd0
B0
B1
Quantity of bonds
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The Nominal Interest Rate and Economic
Growth
20
Percent per year
16
Treasury
bill rate
12
8
4
Real GDP
growth
0
-4
1960 1965 1970 1975 1980 1985 1990 1995 2000
Year
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Economics Focus 6.2: Measuring Real GDP
Product
Expendit
ure
Base
year
Quantitie
s
consume
d
Base
year
Price
Base
year
Expendit
ure
Current
year
Quantitie
s
consume
d
Current
year
Price
Current
year
Haircut
$300 30
$10
$400 20
$20
Watches
$200 10
$20
$500 20
$25
GDP
$500
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$900
Economics Focus 6.2: Measuring Real GDP [Cont’d]
Fixed-Weight method
(Base year prices)
Fixed-weight
(Current year prices)
[20*$10+20*$20]/$50
0=
1.2
GDP rises by 20%
$900/[30*$20+10*$25
] = $900/$850=
1.06
GDP rises by 6%
Averaging the two
yields:
SQRT(1.20*1.06)=
1.13
GDP rises by 13%
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Liquidity Preference Theory

Focus is on the role of monetary policy
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Liquidity Preference Theory


Focus is on the role of monetary policy
Demand for money (Md) is determined by the
preferences of holders of money ( M1)
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Liquidity Preference Theory



Focus is on the role of monetary policy
Demand for money (Md) is determined by the
preferences of holders of money ( M1)
Supply of Money is determined by the central
bank and the financial sector
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Liquidity Preference Theory

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
Focus is on the role of monetary policy
Demand for money (Md) is determined by the
preferences of holders of money ( M1)
Supply of Money is determined by the central
bank and the financial sector
The interaction of money demand/supply
produces an equilibrium interest rate
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Why Hold Money?

TRANSACTIONS MOTIVE: used in the buying
and selling of goods and services
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Why Hold Money?


TRANSACTIONS MOTIVE: used in the buying
and selling of goods and services
PRECAUTIONARY MOTIVE: used as a “buffer”
against unexpected events
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Why Hold Money?



TRANSACTIONS MOTIVE: used in the buying
and selling of goods and services
PRECAUTIONARY MOTIVE: used as a “buffer”
against unexpected events
SPECULATIVE MOTIVE: represents one asset
in a “portfolio” of assets
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Analysis of Monetary Policy
Static Analysis
Dynamic Analysis
Money Supply
Money Supply
g=0
Ms
1
g=0
g><0
g=0
MS
0
Time
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 = {[MSt - MSt-1]/MSt-1} X 100
Time
Figure 6.10. Contractionary Monetary Policy
Nominal interest rate
Ms1
R*1
R*0
Ms0
•
•E
Md0
M*1 M*0
Quantity of money
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Money Growth and Interest Rates
25
Percent per year
20
15
Average money
supply growth
Treasury
bill rate
10
5
0
-5
1965 1970 1975 1980 1985 1990 1995 2000
Year
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The (Dynamic) Link Between Money Growth
and the Interest Rate

1
0
2
Time
R
R1
R2
R0
Time
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The Liquidity Trap

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When nominal interest
rates are close to zero
can monetary policy be
effective
The Liquidity Trap


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When nominal interest
rates are close to zero
can monetary policy be
effective?
It has been suggested
that monetary policy is
then like pushing on a
string
The Liquidity Trap



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When nominal interest rates
are close to zero can
monetary policy be effective?
It has been suggested that
monetary policy is then like
pushing on a string
But, monetary policy is more
than just changing the money
supply or even changing
interest rates. Its about
changing expectations of
future inflation. The trap can,
in principle, be avoided
Summary
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There are 2 theories of interest rate determination: the
loanable funds and liquidity preference models
Loanable funds focuses on the bond market
Liquidity preference focuses on the demand for money
and the role of monetary policy
Equilibrium interest rates change because of changes in
liquidity, risk, expectations, govt and central bank
policies
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