Loanable Funds Market

  • Loanable funds market

    • hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders

  • Savers are the ones who save the money and thus are more willing to lend out at higher rates of return

    Interest rate, r 4 •x $ 150 450 Supply of loanable funds, S Quantity of loanable funds (billions of dollars)

  • Borrowers (ie. firms with investment spending projects) prefer lower interest rates

    Interest rate, r 12% 4 $150 450 Demand for loanable funds, D Quantity of loanable funds (billions of dollars)

  • Equilibrium in the Loanable Funds Market

    • quantity of funds that savers want to lend equals the quantity of funds that businesses want to borrow

    Interest rate, r 12% 4 Projects with rate of return 8% or greater are funded. D $300 S Offers not accepted from lenders who demand interest rate of more than 8%. Projects with rate of return less than 8% are not funded. Offers accepted from lenders willing to lend at interest rate of 8% or less. Quantity of loanable funds (billions of dollars)

Shift of Demand for Loanable Funds

Interest rate, r ... leads to r 2 a rise in the equilibrium interest rate. rl s An increase in the demand for loanable funds Quantity of loanable funds

  • Changes in perceived business opportunities

    • If businesses see opportunities of higher return, the demand for loanable funds will increase

    • In the late 1990s with the dot com boom, firms were excited about any possible internet company out there and the demand for loanable funds increased to right

  • Changes in the government's borrowing

    • When governments incur a deficit, the demand for loanable funds will increase

    • Crowding out occurs when interest rates increase and therefore, businesses will invest less. Thus, the crowding out effect

Shift of Supply for Loanable Funds

Interest rate, r leads to rl a fall in the equilibrium interest rate. An increase in the supply of loanable funds . .. Quantity of loanable funds

  • Changes in private saving behavior

    • Between 2000 and 2006, rising home prices caused people to "feel richer" and therefore spend more and save less

    • The supply of loanable funds, therefore, would shift to the left as a result

  • Changes in capital inflows

    • With a large inflow of capital funds, the supply of loanable funds shifts to the right

    • Conversely, when international investors flee (like in Argentina), the supply of loanable funds shift to the left

Inflation and Interest Rates

Nominal interest rate 14% 4 0 Demand for loanable funds at 10% expected inflation Demand for loanable funds at 0% expected inflation Supply of loanable funds at 10% expected inflation Supply of loanable funds at 0% expected infiation Q\* SIO DIO Quantity of loanable funds

  • Inflation will tend to help borrowers and hurt savers

  • In the late 1970s and early 1980s, homeowners "won" with inflation and banks "lost" with inflation

  • Real interest rate = Nominal interest rate - inflation rate

  • The true cost of borrowing is the real, not nominal, interest rate!

  • A good "hedge" against inflation would be to buy a house and take on a low-interest rate mortgage and invest in other assets, perhaps the stock market

  • Fisher effect

    • The expected real interest rate is unaffected by the change in expected future inflation.

    • Borrowers and lenders base decisions on the expected real interest rate not the nominal

Interest Rate in the Short Run

  • A fall in the interest rates leads to a rise in investment spending, which leads to a rise in GDP, which leads to a rise in savings

  • In the money market, an increase in the money market shift the MS to the right, lowering r

  • In the short run, the loanable funs market follows the lead of the money market.

  • The change in GDP increase savings(investment) and shifts supply of loanable funds to the right

(a) The Liquidity Preference Model of the Interest Rate Interest rate, r MSI rl Fil Interest rate, r In the short run, an increase in the money supply reduces the interest rate .. MDI Quantity of money (b) The Loanable Funds Model Of the Interest Rate . which leads to a short-run increase in real GDP and an increase in the supply of loanable funds. Quantity of loanable funds

Interest Rate in the Long Run

  • In the long run, however, when the money supply increases, the aggregate price level increase and therefore the money demand increase in the same proportion

  • So, MS1 shifts to MS2, but MD1 shifts to MD2, which raises the interest back to its original level

  • As a result, the supply of loanable funds which originally shifted to the right, shifts back to the left, back to its original level!

  • In the long run, money doesn't matter!

  • The supply and demand for loanable funds determines the interest in the long run

(a) The Liquidity Preference Model of the Interest Rate Interest rate, r 1. In the long run, the rise in the price level shifts the money demand curve to the right, . MSI .. which raises the interest rate back to its original level ... Interest rate, r MDI MD2 Quantity of money (b) The Loanable Funds Model of the Interest Rate .. reducing real GDP and the supply of loanable funds until aggregate output equals potential output. Quantity of loanable funds

Practice Question

  • If the Fed sells government securities, what happens in the money market? What will happen in the loanable funds market in the short-run?

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  • In the long-run, if the Fed sells government securities, what happens in the money market? What will happen in the loanable funds market?

    d Loamble

  • Does each of the following affect either the supply or demand for loanable funds, and if so, does the affected curve shift to the right or shift to the left

  • Decreases in capital inflow into the economy

    ↓ Supply of Loanable Funds, Shift Left

  • Business are optimistic about future business conditions

    ↑ Demand for Loanable Funds, Shift Right

  • The government decreases borrowing

    ↓ Demand for Loanable Funds, Shift Left

  • The private savings rate increases

    ↑ Supply of Loanable Funds, Shift Right

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