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Copyright © 2004 South-Western
TheTheLoanable Funds Loanable Funds
MarketMarket
Mod Mod 2929
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Two Models of the Interest Rate
Liquidity Preference Model Loanable Funds Market
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THE MARKET FOR LOANABLE FUNDS
• The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.
• Loanable fundsLoanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.
• Financial markets coordinate the economy’s saving and investment in the market for market for loanable funds.loanable funds.
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Supply and Demand for Loanable Funds
• The SUPPLY of loanable funds comes from people who have extra income they want to save and lend out.
• The DEMAND for loanable funds comes from households and firms that wish to borrow to make investments.
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Supply and Demand for Loanable Funds
• The interest rate is the “PRICE” of a loan.
• It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.
• The interest rate in the market for loanable funds is the real interest rate.
• The equilibrium of the supply and demand for loanable funds determines the real interest rate
The Market for Loanable Funds
Loanable Funds(in billions of dollars)
0
Real InterestRate
RIR
Supply
Demand
%
Q
Copyright©2004 South-WesternQLF
Copyright © 2004 South-Western
Supply and Demand for Loanable Funds
• Government Policies That Affect Saving and Investment
1. Taxes and saving
2. Taxes and investment
3. Government budget deficits
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Policy 1: Saving DISincentives
• Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.
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Policy 1: Saving Incentives
• A tax decrease increases the incentive for households to save at any given interest rate. • The supply of loanable funds curve shifts to the
right.• The equilibrium interest rate decreases.• The quantity demanded for loanable funds
increases.
• If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.
An Increase in the Supply of Loanable Funds
Loanable Funds(in billions of dollars)
0
InterestRate
Supply, S1 S2
2. . . . whichreduces theequilibriuminterest rate . . .
3. . . . and raises the equilibriumquantity of loanable funds.
Demand
1. Tax incentives forsaving increase thesupply of loanablefunds . . .
5%
$1,200
4%
$1,600
Copyright©2004 South-Western
Copyright © 2004 South-Western
Policy 2: Investment Incentives
• An investment tax credit increases the incentive to borrow.• Increases the demand for loanable funds.• Shifts the demand curve to the right.• Results in a higher interest rate and a greater
quantity saved.
• If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.
An Increase in the Demand for Loanable Funds
Loanable Funds(in billions of dollars)
0
InterestRate
1. An investmenttax creditincreases thedemand for loanable funds . . .
2. . . . whichraises theequilibriuminterest rate . . .
3. . . . and raises the equilibriumquantity of loanable funds.
Supply
Demand, D1
D2
5%
$1,200
6%
$1,400
Copyright©2004 South-Western
Copyright © 2004 South-Western
Policy 3: Government Budget Deficits
• A budget deficit increases the demand for loanable funds. • Shifts the demand curve to the right. • Increases the equilibrium interest rate.• Reduces the equilibrium quantity of loanable funds.
• The deficit borrowing crowds out private borrowers who are trying to finance investments.
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The Effect of a Government Budget Deficit
Loanable Funds(in billions of dollars)
0
InterestRate
1.Government borrowing increases thedemand for loanable funds . . .
2. . . . whichraises theequilibriuminterest rate . . .
3. . . . and raises the equilibriumquantity of loanable funds.
Supply
Demand, D1
D2
5%
$1,200
6%
$1,400
Copyright©2004 South-Western
Copyright © 2004 South-Western
Policy 4: Government Budget Surpluses
• A budget surplus increases the supply of loanable funds:• Shifts the supply curve to the right • Decreases the equilibrium interest rate.• Increases the equilibrium quantity of loanable
funds.
• When government increases national saving by running a surplus, the interest rate falls and investment rises.
The Effect of a Government Budget Surplus
Loanable Funds(in billions of dollars)
0
InterestRate
Supply, S1 S2
2. . . . whichreduces theequilibriuminterest rate . . .
3. . . . and raises the equilibriumquantity of loanable funds.
Demand
1. A budget surplusiincreaser thesupply of loanablefunds . . .
5%
$1,200
4%
$1,600
Copyright©2004 South-Western
Copyright © 2004 South-Western
A Summary of Shifts of Supply or Demand for Loanable Funds
• Shifts of Supply:• Changes in Savings Behavior• Changes in Capital Inflows
• Shifts of Demand• Changes in Business Opportunities for investment• Changes in Government Borrowing
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The Loanable Funds Graph
• Worksheet Practice
