Market for Loanable Funds Chap-9 · We will use a basic Supply and Demand Graph to analyze this market The Market for Loanable Funds is NOT a real place. It is a composite representation

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Market_for_Loanable_Funds_Chap-9

� We will use a basic Supply and Demand Graph to analyze this market

� The Market for Loanable Funds is NOT a real place.

� It is a composite representation of the financial market/system where:

1. people/businesses/governments WITH money supply it to others, and inreturn get an interest rate they EARN for supplying that money.

2. People/businesses/government s WITHOUT money borrow it from others, and in return get an interest rate they PAY for demanding that money.

2

Real

Interest

Rate

Quantity of Loanable Funds

r*

QLF*

Demand for Loanable Funds*

(Consumers/Businesses)

Supply of Loanable Funds*

(Consumers/Businesses/Governments)

Market for Loanable Funds

3

Real

Interest

Rate


r*

QLF*






When Consumers/Businesses or

Governments have surplus

Funds they may want to

Place them in some type of

Savings and/or Investment

4

Real

Interest

Rate


r*

QLF*






This surplus savings is put

Into the financial system

As a SUPPLY SUPPLY SUPPLY SUPPLY of Loanable

Funds

This surplus savings is put

Into the financial system

As a SUPPLY SUPPLY SUPPLY SUPPLY of Loanable

Funds

5

Real

Interest

Rate


r

*

QLF*






What these savers/investors care about

Is the REAL INTEREST RATE REAL INTEREST RATE REAL INTEREST RATE REAL INTEREST RATE they will

Earn on their money.

Remember the Real Interest Rate is what

You will earn AFTERAFTERAFTERAFTER inflation is factored

out

6

Real

Interest

Rate


r

*

QLF*











out






out

7

Real Interest Rate = Nominal Interest Rate - Inflation

Real

Interest

Rate


r*

QLF*






8

The Demand for Loanable Funds comes

From Consumers/Business/Governments

Who donWho donWho donWho don’’’’t have money, t have money, t have money, t have money, but want to borrow

It to finance their purchases

Real

Interest

Rate


r*

QLF*






9

What these BORROWERS care about


PAY on the money they BORROW.



out

Real

Interest

Rate


r*

QLF*






10

What these BORROWERS care about


PAY on the money they BORROW.



out

Real Interest Rate = Nominal Interest Rate - Inflation

Real

Interest

Rate


r*

QLF*






The REAL INTEREST RATE is a Long-Term interest

rate that both Borrowers AND savers are going

to consider when making decisions

11

Real

Interest

Rate


r*

QLF*






12

The Struggle EnsuesThe Struggle EnsuesThe Struggle EnsuesThe Struggle Ensues…………....

Demanders for Loanable Funds desire a

LOWERLOWERLOWERLOWER Real Interest Rate because for :

1. Consumers Consumers Consumers Consumers it makes the purchases of houses,

Cars, Big Screen T.V.’s, etc LESS LESS LESS LESS expensive

Real

Interest

Rate


r*

QLF*






13




1. BusinessesBusinessesBusinessesBusinesses it makes the purchases of Capital

Goods, expanding facilities, or building new

facilities LESSLESSLESSLESS expensive

Real

Interest

Rate


r*

QLF*






14




1. BusinessesBusinessesBusinessesBusinesses it makes the purchases of Capital

Goods, expanding facilities, or building new

facilities LESSLESSLESSLESS expensive

Real

Interest

Rate


r*

QLF*






15


The SUPPLIERS SUPPLIERS SUPPLIERS SUPPLIERS of Loanable Funds desire a

HIGHERHIGHERHIGHERHIGHER Real Interest Rate because it makes the

Money they saved/invested GROW LARGERGROW LARGERGROW LARGERGROW LARGER.

Real

Interest

Rate


r*

QLF*






16

Assume the Market for Loanable Funds is

In equilibrium at “r*”. At this Real Interest

Rate Demanders will demand QLF* and

Suppliers will supply QLF*. This is the

Market clearing “price”.

Real

Interest

Rate


r*

QLF*






17

ASSUMPTIONASSUMPTIONASSUMPTIONASSUMPTION

Assume the U.S. Government pursues an

Expansionary Fiscal Policy that requires it to

Deficit Deficit Deficit Deficit spend (spend MORE than they bring

In in Tax Revenue.

Real

Interest

Rate


r*

QLF*






18

In order to do this they will need to BORROWBORROWBORROWBORROW

Money (assuming they don’t just print it). The

U.S Government will enter the Market for

Loanable Funds as a DEMANDER DEMANDER DEMANDER DEMANDER (remember,

They don’t have money, they want it).

Real

Interest

Rate


r*

QLF*






19

This policy will INCREASE INCREASE INCREASE INCREASE the

Demand for Loanable Funds

QLF₁

r₁

DLF₁ (Consumers/Businesses AND GOVERNMENT)

Real

Interest

Rate


r*

QLF*






20

QLF₁

r₁


Real

Interest

Rate


r*

QLF*






21

QLF₁

r₁


The REAL INTEREST RATE INCREASED REAL INTEREST RATE INCREASED REAL INTEREST RATE INCREASED REAL INTEREST RATE INCREASED

Because of Government Deficit Spending!!!

Real

Interest

Rate


r*

QLF*






22

QLF₁

r₁


The REAL INTERESTREAL INTERESTREAL INTERESTREAL INTEREST is HIGHER HIGHER HIGHER HIGHER than

Before, so NOW for Consumers and/or

Businesses to BORROW BORROW BORROW BORROW will be MOREMOREMOREMORE

Expensive due to the new Government policy

Real

Interest

Rate


r*

QLF*






23

QLF₁

r₁


This reduction in Consumer/Business borrowing because of Govt. deficit spending is

Called ““““THE CROWDING OUT EFFECTTHE CROWDING OUT EFFECTTHE CROWDING OUT EFFECTTHE CROWDING OUT EFFECT”””” of PRIVATE SPENDINGPRIVATE SPENDINGPRIVATE SPENDINGPRIVATE SPENDING. (C + I)

Real

Interest

Rate


r

*

QLF*






24

QLF₁

r₁


This is illustrated by the difference between the two equilibriuThis is illustrated by the difference between the two equilibriuThis is illustrated by the difference between the two equilibriuThis is illustrated by the difference between the two equilibrium ratesm ratesm ratesm rates

Real

Interest

Rate


r*

QLF*






25

QLF₁

r₁


How much The Crowding Out Effect The Crowding Out Effect The Crowding Out Effect The Crowding Out Effect impacts

the economy is dependent upon how responsivehow responsivehow responsivehow responsive

Consumers and BusinessesConsumers and BusinessesConsumers and BusinessesConsumers and Businesses are to changes in

The REAL INTERERST RATE

� If consumers and business are HIGHLY responsive to increases in interest rates then the Crowding Out Effect on Govt. spending will be “COMPLETE Crowding Out Effect”

� If consumers and business are partially responsive to increases interest rates then the Crowding Out Effect of Govt. spending will be “Partial Crowding Out Effect”

� If consumers and businesses are NOT responsive to changes in interest rates then there will be No Crowding Out Effect of Govt. spending.

26

Crowding Out Effect

and AD/AS

27

Price

Level

Real GDP

FE

GDP

SRASLRAS

AD*

AD/AS is indicating the

Economy is in a severe

Recession. Assume Govt.

Spending INCREASES

(through BORROWING)

And the economy returns

To Full-Employment RGDP




Spending INCREASES

(through BORROWING)

And the economy returns

To Full-Employment RGDP

RGDP*

PL*

PL₁

AD₁

This would suggest that C + I are NOT RESONSIVE to the INCREASE in the REAL INTEREST

RATE. Borrowing by C + I would not be effected---”NO CROWDING OUT EFFECT”

Actual RGDP = Potential RGDP

Crowding Out Effect

and AD/AS

28

Price

Level

Real GDP

FE

GDP

SRASLRAS

AD*




Spending INCREASES

(through BORROWING)

And the economy DOES NOT

Return to Full-Employment

RGDP.




Spending INCREASES

(through BORROWING)

And the economy DOES NOT

Return to Full-Employment

RGDP.

RGDP*

PL*PL₁AD₁

This would suggest that C + I are PARTIALLY RESPONSIVE to the INCREASE in the REAL INTEREST

RATE. Borrowing by C + I would be NEGATIVELY effected---”PARTIAL CROWDING OUT EFFECT”

Actual RGDP < Potential RGDPRGDP₁

Crowding Out Effect

and AD/AS

29

Price

Level

Real GDP

FE

GDP

SRASLRAS

AD*




Spending INCREASES

(through BORROWING)

And the economy STAYS THE

SAME. Any increase in Govt.

Spending is off-set COMPLETLEY

By the decreases borrowing

By consumers and businesses.




Spending INCREASES

(through BORROWING)

And the economy STAYS THE

SAME. Any increase in Govt.

Spending is off-set COMPLETLEY

By the decreases borrowing

By consumers and businesses.

RGDP*

PL*

PL₁

AD₁

This would suggest that C + I are 100% RESPONSIVE to the INCREASE in the REAL INTEREST

RATE. Borrowing by C + I would be 100% NEGATIVELY effected---”COMPLETE CROWDING OUT EFFECT”

Actual RGDP < Potential RGDP

� If Government INCREASES deficit spending and by doing so INCREASES the REAL INTEREST RATE then it may have the following effects:

� No Crowding out effect: Govt. spends and it DOES NOT effect borrowing by C + I and the economy can return to Full-Employment

� Partial Crowding Out: Govt. spends and it DOES effect borrowing by C + I. C + I do not borrow AS MUCH thus potentialLY causing the economy to NOT RETURN TO FULL EMPLOYMENT.

� Complete Crowding Out: Government Spends and it has the effect of causing C + I to NOT borrow and the economy virtually stays the same: NO INCREASE RGDP

30

� If interest rates increase due to Government borrowing AND if it “crowds out” PRIVATE INVESTMENT in the business sector the following could happen:

� Capital projects (expanding facilities, building new facilities) will become less profitable.

� Business will not borrow to replace capital equipment.

� Short term Aggregate Demand will be adversely affected.

� Long Run Aggregate Supply (PPF) will be adversely affected because the CAPITAL STOCK of the economy will become obsolete and/or depleted. Essentially Capital Stock will DECREASE.

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Documents

Market for Loanable Funds Chap-9 · We will use a basic Supply and Demand Graph to analyze this market The Market for Loanable Funds is NOT a real place. It is a composite representation