Download Shifts in Supply and Demand

Shifts in Supply and Demand
The book does a good job explaining the market for loanable funds and explaining how
shifts in supply and demand affect the real interest rate and investment.
The book then offers reasons why supply and demand would shift and hint at others. I
like to be explicit in lecture about what could shift supply or demand.
SAVINGS
What would shift supply of loanable funds?
Since Supply = Total Savings (or “National Savings”)
and Total Savings = Private Savings (from households) + Public Savings (from
government)
Events that would shift supply or savings:
Private Savings
 Change in Consumer Confidence
 Change in Consumer Patience
 Change in current Disposable Income, maybe
 Change in government policy on savings
Public Savings
 Change in the government budget surplus or deficit
Explanations:
Consumer Confidence: Consumer Confidence is a measure of how consumers feel
about their ability to earn income in the future. If consumers feel that they
will be making more income in the future and more likely to hold a well
paying job, consumer confidence has risen. When consumer confidence
rises, consumers, optimistic about the future, will start consuming more
now and saving less. If consumers feel they will be making less income in
the future or likely to lose or not hold a job, consumer confidence has
fallen. When consumer confidence falls, consumers, pessimistic about the
future, will prepare for that future by saving more today and cutting back
on current consumption. Important Note: consumer confidence is not
confidence in one “thing” such as the Federal Reserve, the President, or
the Stock Market. Consumer confidence is specifically a statement about
consumers’ expectations about earning disposable income in the future.
Consumer confidence is about future income.
Consumer Patience: Consumer Patience is a measure of consumers’ willingness to
wait. Savings is about postponing consumption today, earning interest,
and consuming more in the future. If consumers are more willing to wait,
consumer patience has risen, and private savings will increase. If
consumers are less willing to wait, they want it now, consumer patience
has fallen, and private savings will decrease.
Disposable Income: Disposable income is the difference between income and
taxes. It is “after-tax” income. As disposable income rises, consumers
can increase savings if they don’t increase consumption by an equal
amount. That’s a big “if”, which is why there’s a “maybe” attached to
changes in disposable income. If disposable income rises (income rises or
taxes decrease), consumers may save more or they may not (instead,
selecting to increase consumption spending).
Government Policy on Savings: The book covers this one well. The government
can change policies about savings to encourage more savings or
discourage savings. An example would be to reduce taxes on interest
income or expand tax deferred retirement programs, such as IRA’s.
Government Budget Surplus or Deficit: If the government increases a budget
surplus or reduces a budget deficit, this is an increase in public savings.
Conversely, if the government reduces a budget surplus or increases a
budget deficit, this is a decrease in public savings.
What would increase Total Savings?
 Decrease in Consumer Confidence
 Increase in Consumer Patience
 Increase in Disposable Income, maybe
 Improved government policy towards savings
 Increased government budget surplus (or reduced deficit)
What happens if total savings increases?
o The real interest rate falls
o Quantity of investment rises (as a result of the lower real interest rates)
o The economy grows more rapidly
The reverse of the above would be the causes and results of a decrease in Total Savings
INVESTMENT
What would shift demand for loanable funds?
Demand for loanable funds = investment
Remember: in macroeconomics, investment is the purchase of new capital (physical or
human) or new technology (research and development). This use of the word investment
is different from “financial investment” which is the purchase of stocks, bonds, or real
estate.
Some things to note about investment:

Businesses invest to increase future profits

There are many investment projects to choose from. There are lots of options.
The choice is not about investing or not investing. The choice is more
complicated. It’s about how much to invest and in what to invest.

Not all investments are equal. Businesses invest to increase profits. But not all
investment projects will increase profits equally. And some investments might
decrease profits (bad investments). Often people talk about the “return” on
investment. The return on investment projects does vary from project to project

Investment is about spending on capital (or technology) today in order to increase
profits in the future. Since the return comes in the future, businesses must find a
funding source for investment which is why they demand funds in the loanable
funds market.

Because firms borrow to invest, the interest rate is a “cost of capital”. Businesses
pay interest in order to fund investment, thus the interest rate is the cost of
acquiring capital.

Businesses should fund and invest in all “good” investments. Good investments
are those that will increase the net worth of the company and whose profitability
is sufficient to pay the cost of the investment including the cost of capital (the
interest rate).

As the interest rate rises and capital becomes more expensive, some profitable
“good” investments will become unprofitable “bad” investments and a business
should no longer undertake those investments. Thus, as the interest rate rises,
demand for investment will decrease.
Events that would shift demand or investment:
 Change in Technology
 Change in Investor Sentiments
 Change in government policy on investment
Explanations:
Technology: with new technology, firms will invest in capital (both physical and
human) to make use of that technology.
Investor Sentiments: investor sentiments are the expectations business owners
have concerning their ability to sell their products in the future.
Investment is about spending today to be able to produce more in the
future. If business owners are optimistic about their ability to sell more
products for a higher price in the future, they’ll want to build towards that
future. Conversely, if business owners are pessimistic about the future,
that sales will be flat or lower and prices will be lower, they’ll want to not
spend money now to expand future production capacity.
Change in government policy on investment: the book covers this one well. The
government can alter policies that will encourage or discourage
investment. For example, to encourage investment, the government might
offer tax break incentives, often referred to as ITC’s (investment tax
credits), to businesses that invest.
What would increase Investment?
 New Technology
 Improved Investor Sentiments (Investors optimistic)
 Improved government policy towards investment
What happens if investment increases?
o The real interest rate rises
o Quantity of investment rises (as a result of the increased savings from the
higher real interest rate)
o The economy grows more rapidly
The reverse of the above would be the causes and results of a decrease in Investment with
one exception. The one exception is that technology does not decrease.