The Market for Loanable Funds

THE MARKET FOR LOANABLE FUNDS

The Market for Loanable Funds

For the economy as a whole, savings always equals investment spending

In a closed economy, savings is equal to national savings

In an open economy, savings is equal to national savings plus capital inflow

Equilibrium Interest Rate

The Loanable funds market is a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders


The price that is determined in the loanable funds market is the interest rate, r.

It is the return that a lender receives for allowing borrowers the use of a dollar for one year, calculated as a percentage of the amount borrowed


The rate of return on a project is the profit earned on the project expressed as a percentage of its cost.

A business will want a loan when the rate of return on its project is greater than or equal to the interest rate

Interest rate

12%

4

0 $150 450Quantity of loanable

funds(billions of dollars)

Demand for loanable funds, D

Interest rate

12%

4

0 $150 450Quantity of loanable funds(billions of dollars)

Supply of loanable funds, S


Savings incur an opportunity cost when they lend to a business; the funds could instead be spent on consumption

Whether a given individual becomes a lender by making funds available to borrowers depends on the interest rate received in return


The equilibrium interest rate is the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded

Interest rate

12%

8

4

0$300 Quantity of loanable

funds(billions of dollars)

Offers not accepted fromlenders who demand interestrate of more than 8%.

Projects with rate of returnless than 8% are not funded.

Projects with rate of return8% or greater are funded.

Offers accepted fromlenders willing to lend atinterest rate of 8% or less.

r*

Q*

Equilibrium Interest Rate Match up of funds is efficient1. The right investments get made: the

investment spending projects that are actually financed have higher rates of return than those that do not get financed

2. The right people do the saving: the potential savers who actually lend funds are willing to lend for lower interest rates than those who do not

Shifts of the Demand for Loanable Funds

1. Changes in perceived business opportunities

Business opportunities in the 90s with the Internet

2. Changes in government’s borrowing Changes in budget deficits can shift the

demand curve

An Increase in the Demand for Loanable Funds

Interest rate

r2

r1

Quantity of loanable funds

(billions of dollars)

An increase

in the demand

for loanablefunds . . .

. . . leads toa rise in theequilibriuminterest rate.

Shifts of the Demand for Loanable Funds

Fact that an increase in the demand for loanable funds leads, other things equal, to a rise in the interest rate has one especially important implication:Beyond concern about repayment, there

are other reasons to be wary of government budget deficits

Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending

Shifts of the Supply of Loanable Funds

1. Changes in private savings behavior: Between 2000 and 2006 rising home prices in the United States made many homeowners feel richer, making them willing to spend more and save less This shifted the supply of loanable funds to the left.

2. Changes in capital inflows: The U.S. has received large capital inflows in recent years, with much of the money coming from China and the Middle East. Those inflows helped fuel a big increase in residential investment spending from 2003 to 2006. As a result of the worldwide slump, those inflows began to trail off in 2008.

Interest rate

r1

r2

Quantity of loanable funds(billions of dollars)

An increasein the supply of loanablefunds . . .

. . . leads toa fall in theequilibriuminterest rate.

Inflation & Interest Rates

Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate.

Historically, major changes in interest rates have been driven by many factors, including:changes in government policy. technological innovations that created new

investment opportunities.


However, arguably the most important factor affecting interest rates over time is changing expectations about future inflation.

This shifts both the supply and the demand for loanable funds.

This is the reason, for example, that interest rates today are much lower than they were in the late 1970s and early 1980s.


Real interest rate = nominal interest rate - inflation rate

In the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal. Actual loan contracts, therefore, specify a nominal interest rate rather than a real interest rate.


According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.

The central point is that both lenders and borrowers base their decisions on the expected real interest rate

The Fisher EffectNominal interest rate

Quantity of loanable funds

Q*

14%

4

0

E10

S10

S0

D0

E0

D10

The Interest Rate in the Short Run

As explained before, using the 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 doesn’t lead only a to a rise in consumer spending but it also leads to a rise in savings, at each stage of the multiplier process, part of the increase in disposable income is saved


How much do savings rise? Savings-investment spending identity

states that total savings in the economy is always equal to investment spending

When a fall in interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending


In the short run, the supply and demand for money determine the interest rate, and the loanable funds market follows the lead of the money market

When a change in the supply of money leads to a change in the interest rate, the resulting change is real GDP causes the supply of loanable funds to change as well

Interest Rates in the Long Run

In the long run, changes in the money supply don’t affect the interest rate

Interest Rates in the Long Run

What determines the interest rate in the long run is supply and demand for loanable funds

In the long run, the equilibrium interest rate is the rate that matches the supply of loanable funds with the demand for loanable funds when real GDP equals potential output

Documents

The Market for Loanable Funds