Loanable Funds Market Jump to first page Copyright

Loanable Funds Market Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

The Circular Flow Diagram • Four key markets coordinate the circular flow of income. • The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income. • The goods & services market coordinates the demand for and supply of domestic production (GDP). • The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. • The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

Loanable Funds Market • The interest rate coordinates the actions of borrowers and lenders. • • • From the borrower's viewpoint, interest is the cost paid for earlier availability. From the lender’s viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future. The money and real interest rate: • • When inflation is anticipated, lenders will demand (and borrowers pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar. This premium for the expected decline in purchasing power of the dollar is called the inflationary premium. Real interest rate = Money interest rate Jump to first page – Inflationary premium Copyright 2003 South-Western Thomson Learning. All rights reserved.

Inflation and Interest Rates Loanable Funds market Interest Rate S(stable prices expected) Here, the money and real interest rates are equal i = r =. 05 D(stable prices expected) Q • • Quantity of funds Suppose that when people expect the general level of prices to be stable (zero inflation) in the future, a 5% interest rate brings equilibrium in the loanable funds market. Under these conditions, the money and real interest rates will be equal (here 5%). Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

Inflation and Interest Rates Loanable Funds market Interest Rate S(5% inflation expected) S(stable prices expected) Inflationary premium equals expected rate of inflation i =. 10 D r =. 05 (5% inflation expected) D(stable prices expected) Q • Quantity of funds When people expect prices to rise at a 5% rate, the money interest rate (i) will rise to 10% even though the real interest rate (r) remains constant at 5%. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

Interest Rates and Capital Flows Domestic saving Interest Rate Loanable Funds market Supply of loanable funds Capital inflow r 2 r 0 r 1 D 2 Capital outflow D 1 D 0 Q 1 Q 0 • • • Q 2 Quantity of Funds Demand supply in the loanable funds market will determine the interest rate. When demand for loanable funds is strong (D 2), real interest rates will be high (r 2) and there will be a inflow of capital. In contrast, weak demand (D 1) and low interest rates (r 1) will lead to capital outflow. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

Leakages and Injections from the Circular Flow of Income Net Saving + Imports - Exports = Investment + Budget Deficit • Budget deficit = (government purchases - taxes): Government Net Saving + Imports - Exports = Investment + Purchases - Taxes • Which may be re-written as: Net Saving + Imports + Taxes = Investment + Government Purchases + Exports Leakages • Injections Therefore, when the loanable funds and foreign exchange markets are in equilibrium, leakages from the circular flow of income (savings + imports + taxes) are equal to injections into it (investment + government purchases + exports). Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.

The Circular Flow Diagram • Macro equilibrium will be present when the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop). • This condition will be present when the injections (investment, government purchases, & exports) into the circular flow … equal the leakages (saving, taxes, and imports) from it. • Hence, when equilibrium is present in the loanable funds and foreign exchange markets, injections equal leakages and Macro equilibrium will be present. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved.