Loanable Funds

By Mike Fladlien

Muscatine

What is Loanable Funds?

Demand SupplyLoanable

Funds

Banks

Households

Financial Markets

Investment by Firms

Flows of Funds Through the Financial System

BanksCentral BankOMO’s

Monetary Policy

Reserve Ratio

Discount Rate

Banks

Households

Financial Markets

Investment by Firms

Central Bank

Monetary Policy

Financial Markets

Financial Markets

Money Market

Capital Market

Graph of Loanable Funds

Investors and households consider the real interest rate when demanding funds. The government is indifferent to the interest rate when she uses fiscal policy but borrows when she runs a budget deficit.

The supply of Loanable funds comes from private savings, financial investment for abroad, and a government surplus.

Real Interest Rate

i =

r

+

Pi

Supply of Loanable Funds

• Household savings or Private saving

• Government surplus or Public saving

• Net capital flows

Net Exports

• Circular Flow of Income

Net Exports is calculated by subtracting Imports from Exports. That is, Nx = Ex – Im

As an example, If Exports are $10m and Imports are $5m, Net Exports are $5m.

Net exports can be

Positive

Negative

Equal to Zero

Domestic Country’s

GDP

The World

An Import

• What happens when the domestic country buys a good from the world?

Suppose that Sig, a US citizen, buys a doll from Wilhelm in Germany for $20. Assume that Wilhelm buys a US action figure for $10.

What happens?

After a mutual exchange of goods and services, Wilhelm is left with $10 in US currency. This currency can’t be used in Germany.

Wilhelm has only one choice left. He can buy US financial capital such as a bond or a stock in a US country.

Domestic Country’s

GDP

The World

$10 Export

$20 Import

Government Demands Loanable Funds

Government Demands LF

The government will demand loanablefunds when tax revenue is less that the amount that is needed to fund government spending.

In other words, G > T

In this example, if Government spending is $2 million and tax revenue is $1.25 million, the government will borrow $.75 million. In other words, the government will “Demand” loanable funds.

Government

Households

Borrowing

Taxes

Gs

Government Supplies Loanable Funds

Government Supplies LF

The government will supply loanablefunds when tax revenue is greater than the amount that is needed to fund government spending.

In other words, T > G

In this example, if Government spending is $2 million and tax revenue is $2.25 million, the government will supply $.25 million to financial markets. In other words, the government will “Supply” loanablefunds.

Government

Households

Lending

Taxes

Gs

Domestic Country’s

GDP

The World

$10 Export

$20 Import$10 Capital Inflow

Domestic Country’s

GDP

The World

$20 Export

$10 Import$10 Capital Outflow

Investment

Financial Markets

GDP

$1 Million$1 Million

Investment Demand (Ig)

•As RIR changes, the quantity of Investment demanded changes

•Other determinants shift the ID curve:

• costs of capital

•business taxes

•Technology

•expectations

Summary of Capital Flows

• NX = Ex – Im

• 10 = 20 – 10

• There’s a capital outflow

• NX = Ex – Im

• -10 = 10 – 20

• There’s a capital inflow

When Exports are greater than imports, there’s a capital outflow

When Imports are greater than exports, there’s a capital inflow

Net exports = Exports –Imports

Equation for Capital Flows

• How Capital Flows Change the Amount of Investment

• Y = C + Ig + G + Nx

• Y – C – G = Ig + Nx

• S = Ig + Nx

• S – Nx = Ig

To show that savings equals investment for the domestic and international economy, let’s derive the savings and investment equation from the equation for GDP.

I rearrange and interpret the expenditures equation to show how capital flows add too or subtract from national savings.

The expenditures equation is:

Y = C + Ig + G + Nx

Net Exports are Negative

• A Capital Inflow

• S – Nx = Ig

• $10 - -$5 = $15

When net exports are negative, the world holds US currency. Since the world didn’t use the currency to buy US exports, the world must have used the currency to buy US financial capital in the form of stocks and bonds.

When the world buys US financial capital, there’s a capital inflow. This capital inflow represents a supply of Loanable funds to US firms.

Net Exports are Positive

• A Capital Outflow

• S – Nx = Ig

• $10 - $5 = $5

When net exports are positive, the US holds foreign currency. Since the US didn’t use the currency to buy foreign exports, the US must have used the currency to buy foreign financial capital in the form of stocks and bonds.

When the US buys foreign financial capital, there’s a capital outflow. This capital outflow represents a supply of Loanable funds to foreign firms.

When there’s a capital outflow, there are less Loanable funds available to loan US, or domestic, firms.

Note: Capital Inflows

• What Does a Capital Inflow Mean to the Domestic Country?

When a country imports more than she exports, foreign country’s hold claims to US assets. Some people might say that the US is selling off part of its country.

This cartoon shows that as the US imports more than it exports, China owns more and more of US assets.

At this writing, the debt to GDP ratio in the US is 160%.

Do Capital Inflows Mean Investment?

Capital Inflow Imports > Exports

• Beginning with the identity– Y = C + I + G + Nx

– I = S – Nx

• Infers that investment includes capital inflow

• What are your thoughts?

Financial Markets

Budget Deficit

Budget Surplus

Capital Outflow

Capital Inflow

Investment

Private Savings

Economist – blocked pipes

This cartoon by David Simonds shows that banks are the main source of liquidity for businesses, consumers,

and other banks. When the banks won’t lend, the economy clogs up. A well functioning credit market is necessary for a healthy economy.

The Economist discusses the role of financial markets here.

Mikeroeconomics.blogspot.com

has a complete video on financial and capital markets here.

Money Market

NIR

Q1Q

MD

MS

i1

•MS – affected by actions of theFederal Reserve

•MD –•Transaction demand

determined by GDP•Asset demand

determined by NIR

MS MS

Md

Inte

rest

Rat

e

Money Market

Quantity Quantity

Inte

rest

Rat

e

Real GDP

Pri

ce L

evel

Ig

AD/AS

AS

LRS

AD

AD’

Quantity

Inte

rest

Rat

e

I

S

S’

Monetary Policy

FED Buys Bonds MS

1/(1-MPC)Savings Loanable Funds

Interest Rate

The Heart of Any Economic System

• I used the metaphor of a heart to show how the flows into and out of the financial system fuels economic growth.

• St. Louis FED article

Loanable Funds Beginning with a Budget Surplus

Initially the Loanable Funds market is in equilibrium at r and QLF. At Point 1 the government as a budget surplus of $25 million.

Suppose that tax revenue is $100 million and Government spending is $75 million., the surplus would be $25 million.

If the government spends $20 million to stimulate the economy, then the supply curve shifts to the left, increasing the interest rate from r to r;.

Loanable Funds with Reduction of Budget Surplus and Demand

At Point 1 the government spends her $25 million surplus and the supply curve shifts to the left. Since the demand for LF would be higher than the supply, the interest rate rises to Point 2a.

The government now demands $5 million to stimulate the economy so the demand shifts to the right.

The new equilibrium is point 2b at a higher interest rate of 7%.

Investment Demand when Inflation is Negative

This shows that unanticipated inflation hurts investors. I derived this because I wanted to make the point that the real interest rate is the basis for the demand curve. To show this I simply used the Fisher equation. A rise in the real interest rate is a change in quantity demanded.

• Fischer Equation: r = i – π

• When inflation is positive: 7 = 10 – 3

– In this case the real interest rate is 7 when the nominal rate is 10 and inflation is positive

• When inflation is negative: 13 = 10 - - 3

– In this case the real interest rate is 13 when there is deflation

• During deflation the real interest rate is higher so investors will demand a higher ROI. If investors don’t demand a higher real interest rate, then their real interest rate they pay will be higher than the return from their investment.

• Initially, the real interest rate is 3 = 3 - 0

– If deflation lowers the nominal rate by 2, Real interest rate is 5

– This higher real interest might result in a decrease in investment

– Falling interest rates make it more expense to invest

Critical Questions

Capital inflows can represent investment and boost GDP and create jobs for the domestic country. But Capital inflows mean a persistent current account deficit and selling off of domestic capital and assets. So is an open economy good or bad?

Critical Questions

• Should the government enact policies to encourage savings?

• Should there be a ceiling on how much the government can borrow?

Finally

• Send questions or comments to: mfladlien@gmail.com

• Please use liberally in any way that you want