Module 29 The Market for Loanable Funds Module

Module 29 The Market for Loanable Funds

Module 29 Essential Questions 1. 2. 3. How does the loanable funds market match savers and investors? What are the determinants of supply and demand in the loanable funds market? How can the two models of interest rates can be reconciled?

The Market for Loanable Funds: the Fundamentals • The Equilibrium Interest Rate: • Loanable Funds Market: • Nominal v. Real Interest Rate: • Rate of Return: • The laws of s_____ and d______ explain the behavior of savers and borrowers.

The Market for Loanable Funds: the Fundamentals • The Equilibrium Interest Rate: the interest rate whereby $ to be lent & $ to be borrowed is at equilibrium • Loanable Funds Market: hypothetical market that unites savers & borrowers • Nominal v. Real Interest Rate: money market uses the nominal interest rate while loanable funds uses real interest rate • Rate of Return: profit earned as a % of the cost • The laws of supply and demand explain the behavior of savers and borrowers.

The Market for Loanable Funds Notes Recall the savings investment identity from earlier modules. Closed economy: S = I Add the public sector (government): National savings = p_____s______ + p____savings = I Add the foreign sector: N______savings + c_____inflow ($ from China)= I Financial markets are where the f______ of the s____ are b_____ by investors. Economists use the model of a market for l_____ f____ to explain these interactions and determine the equilibrium real interest rate. The Equilibrium Interest Rate ~ a simplified model whereby it is assumed there is 1 market that brings together those who want to l_____ money (savers) and those who want to b______ (firms with investment spending projects).

The Market for Loanable Funds Notes Recall the savings investment identity from earlier modules. Closed economy: S = I Add the public sector (government): National savings = private savings + public savings = I Add the foreign sector: National savings + capital inflow ($ from China)= I Financial markets are where the funds of the savers are borrowed by investors. Economists use the model of a market for loanable funds to explain these interactions and determine the equilibrium real interest rate. The Equilibrium Interest Rate ~ a simplified model whereby it is assumed there is 1 market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects).

The Market for Loanable Funds Review Notes The 1 hypothetical market that unites these 2 is known as the loanable funds market. The price that is determined in the loanable funds market is the real interest rate, denoted by r. The interest rate on the vertical axis represents the real interest rate, not the nominal. Savers and borrowers care about the real interest rate because that is what they earn or pay after inflation. Real interest rate = nominal interest rate – expected inflation If expected inflation =0%, then: real rate = nominal rate. But it’s also true that if expected inflation is constant, any change in the nominal rate will be reflected in an identical change in the real rate. This is why the graphs in the text are labeled “nominal interest rate for a given expected future inflation rate. ”

Equilibrium in the Loanable Funds Market

Equilibrium in the Loanable Funds Market 1. 2. Demand is downward sloping for one HUGE reason. Why? Supply is upward sloping. Why?

Equilibrium in the Loanable Funds Market 1. Demand is downward sloping for one HUGE reason. Firms borrow to pay for capital investment projects. If the project has an expected rate of return that exceeds the real interest rate, the investment will be profitable, and the funds will be demanded. Rate of return (%) = 100*(Revenue from project – Cost of project)/(Cost of project) As the real rate falls, more projects become profitable, so the quantity of funds demanded will increase. 2. Supply is upward sloping. If Savers lend their money to borrowers, they forgo their own purchases. In order to compensate for the forgone consumption, savers receive interest income & as the real interest rate rises, the opportunity to earn more income rises, so more dollars will be saved. As the real rate rises, the quantity of funds supplied will increase.

Shifts of the Demand for Loanable Funds • ∆ Perceived Business Opportunities: • early 90 s Internet BOOM • Early 2000 s dot. com BUSTS • ∆ Government Borrowing • Budget deficit = War in Iraq 2003 caused demand to increase (Crowding Out effect) • Budget surplus ~ more funds are available

Factors that Shift the Demand for Loanable Funds 1. Changes in perceived business opportunities: 2. Changes in the government’s borrowing:

Factors that Shift the Demand for Loanable Funds 1. Changes in perceived business opportunities: A change in beliefs about the rate of return on investment spending can increase or reduce the amount of desired spending at any given interest rate. If firms believe that the economy is full with profitable investment opportunities, the demand for loanable funds will increase. If firms believe the economy is poised for a recession where profitable investment opportunities will be few and far between, the demand will decrease. 2. Changes in the government’s borrowing: Governments that run budget deficits are major sources of the demand for loanable funds. When the government runs a budget deficit, the Treasury must borrow funds and acquire more debt. This increases the demand for loanable funds in the market. If the government were to run a budget surplus, less debt would be required and the demand for loanable funds would decrease.

Shifts of the Supply of Loanable Funds • ∆ Capital Inflows: • Foreign Investments into USA from China 2003 2006 fueled the housing boom & increase MS • Great Recession: Capital inflow slowed & decreased MS • ∆ Private Savings Behavior: • 2006 homeowners felt richer due to home values increasing; spent more saved less; MS shifted left • Housing Crisis: more $ saved less spent; MS shifts right

Factors that Shift the Supply of Loanable Funds 1. Changes in private savings behavior: 2. Changes in capital inflows:

Factors that Shift the Supply of Loanable Funds 1. Changes in private savings behavior: If households decide to consume more and save less, the supply of loanable funds will shift to the left. 2. Changes in capital inflows: For a variety of economic and political reasons, a nation may receive more capital inflow in a given year. If a nation is perceived to have a stable government, a strong economy and is a good place to save money, foreign money will flow into that nation’s financial markets, increasing the supply of loanable funds.

Inflation and Interest Rates • Real Interest = Nominal Interest Inflation • r% = i% π% The Fisher Effect: the expected real interest rate is unaffected by the change in expected future inflation. • Nominal Interest = Real Interest + Expected Inflation • i% = r% + exp. π%

Inflation & Interest Rates 1. 2. 3. Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the i______ r_______. Unexpected inflation creates w______ and l_____, particularly among borrowers and lenders. Economists capture the effect of inflation on borrowers and lenders by distinguishing between the ______interest rate and the _____interest rate, where the difference is as follows: 4. Real interest rate = _____ interest rate — ____rate 5. For borrowers, the true ______of borrowing is the _______interest rate, not the _____interest rate. 6. For lenders, the true ____to lending is the ____interest rate, not the _____interest rate.

Inflation and Interest Rates 1. 2. 3. Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate. Unexpected inflation creates winners and losers, particularly among borrowers and lenders. Economists capture the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the difference is as follows: 4. Real interest rate = Nominal interest rate — Inflation rate 5. For borrowers, the true cost of borrowing is the real interest rate, not the nominal interest rate. 6. For lenders, the true payoff to lending is the real

Fisher Effect 1. 2. 3. 4. Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): the expected real interest rate is unaffected by the change in expected future inflation. The Fisher effect: increase in e____ f_____ inflation drives up n____ i_____rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by _______point. The central point is that both l____ and b____ base their decisions on the e______ r_______ interest rate. As long as the level of inflation is e____, it does not affect the equilibrium Q______of ______ funds or the expected r_____interest rate; all it affects is the equilibrium n______interest rate.

Fisher Effect 1. 2. 3. 4. Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): the expected real interest rate is unaffected by the change in expected future inflation. The Fisher effect: increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point. The central point is that both lenders and borrowers base their decisions on the expected real interest rate. As long as the level of inflation is expected, it does

Inflation and Interest Rates B A

Reconciling the Two Interest Rate Models: The Interest Rate in the Short Run

Reconciling the Two Interest Rate Models: The Interest Rate in the Short Run 1. 2. 3. 4. 5. 6. Liquidity preference model: a f____ in the interest rate leads to a r_____ in i_____ s______, (denoted with I), which then leads to a r_______ in both real GDP and c______s_____, (denoted with C). The rise in real GDP leads to a rise in consumer spending and also leads to a rise in s_____. Why? at each stage of the m______ process, part of the increase in d______ income is s____. How much do savings rise? Using savings–investment spending identity: total savings in the economy is always e_____ to investment spending. Thus a f____ in the interest rate leads to a r_____ in investment spending, & the resulting increase in real G______ generates enough additional s_____ to match the rise in investment s______. After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded.

Reconciling the Two Interest Rate Models: The Interest Rate in the Short Run 1. 2. 3. 4. 5. 6. Liquidity preference model: a fall in the interest rate leads to a rise in investment spending, I, which then leads to a rise in both real GDP and consumer spending, C. The rise in real GDP leads to a rise in consumer spending and also leads to a rise in savings. Why? at each stage of the multiplier process, part of the increase in disposable income is saved. How much do savings rise? Using savings–investment spending identity: total savings in the economy is always equal to investment spending. Thus a fall in the interest rate leads to higher investment spending, & the resulting increase in real GDP generates enough additional savings to match the rise in investment spending. After a fall in the interest rate, the quantity of savings

Reconciling the Two Interest Rate Models: The Interest Rate in the Long Run The money supply rises from 1 to 2, reducing the interest rate to r 2. In the long run the aggregate price level will rise by the same proportion as the increase in the money supply (due to the neutrality of money). A rise in the aggregate price level increases money demand in the same proportion. So in the long run the money demand curve shifts out to MD 2, and the equilibrium interest rate rises back to its original level, r 1. An increase in the money supply leads to a short run rise in real GDP & that this shifts the supply of loanable funds rightward from S 1 to S 2. In the long run, real GDP falls back to its original level as wages and other nominal prices rise. As a result, the supply of loanable funds, S, which initially shifted from S 1 to S 2, shifts back to S 1. In the long run, then, changes in the money supply do not affect the interest rate. In the long run, the equilibrium interest rate matches the supply and demand for loanable funds that arise at

Reconciling the Two Interest Rate Models: The Interest Rate in the Long Run 1. In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate. Why not?

Reconciling the Two Interest Rate Models: The Interest Rate in the Long Run 1. In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate. Why not? For example: The Fed decides to increase the money supply to hit a target interest rate due to recession. In the short run, interest rates fall, they eventually hit their target, and demand for money increases. This is what the Fed wants; an increase in money supply means consumer spending and saving (think MPC and MPS). An increase in the money supply leads to a SHORT RUN rise in real GDP (consumers spend more with more money available to them but also save too) & that shifts the supply of loanable funds rightward from S 1 to S 2. STOP. This is the end of short run. The money supply HAS affected the interest rate. LONG TERM: GDP has risen. In the long run, real GDP falls back to its original level (LRAS) because wages and other nominal prices rise. (wages are input costs & if they go up, producers respond by reducing supply). As Real GDP goes down, (remember money spent is income to another) there is less consumption & saving. As a result, the supply of loanable funds, S, which initially shifted from S 1 to S 2 , (from above) shifts back to S 1. In the long run, then, changes in the money supply do not affect the interest rate.

The End of Section 5 Test over modules 22 29 Friday November 15