1. LOANABLE FUNDS MARKET

2. SUPPLY and DEMAND for LOANABLE FUNDS  Saving is the source of the supply of loanable funds. -For example, when a household makes a deposit in a bank.  Investment is the source of the demand of loanable funds. -For example, when households take out mortgages to buy homes. Or, when firms borrow to buy new capital equipment.

3.  The interest rate is the price of a loan.  A high interest rate makes borrowing more expensive, thus the quantity of loans demanded falls.  Similarly, a high rate makes savings more attractive, and thus increases the amount of loanable funds supplied.

4.  If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity demanded.  The result is a shortage of funds, which would encourage lenders to raise the interest rate, and thereby increase saving and dissuade borrowing for investment.  Conversely, if interest rates were higher than equilibrium, then the quantity of loans supplied would exceed those demanded.  As lenders competed for scarce borrowers, interest rates would be driven down to reach equilibrium.

5.  Remember, economists distinguish between nominal and real interest rates.  The real interest rate is the nominal rate adjusted for inflation.  Nominal rate = Real interest rate + Inflation Premium.  Real interest rates more accurately reflect the real return. Therefore, the supply and demand for loanable funds depend on the real interest rate.

6. Saving Incentives Policy  American families save a smaller fraction of their incomes as compared to other industrialized countries, like Japan and Germany. (Note: As of 2009, this has changed somewhat due to the current recession. National Savings has increased.)  However, the low savings rate might be due to tax policies in the U.S. Tax on interest income reduces incentives to save.

7.  What if tax incentives were created for people to shelter some of their savings income? How would this impact the market for loanable funds?  First, which curve would this policy affect?

8.  Because the tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate.  Therefore, the supply of funds would shift to the right.  As a result, interest rates would be lower, and investment would increase.

9. Investment Incentives Policy  Suppose Congress decides to pass an investment tax credit to encourage firms to build new factories.  As this is investment policy, it would affect demand. It would change the demand for loanable funds as firms are rewarded for borrowing and investing in new capital.

10.  Next, since firms would have an incentive to increase investment at any interest rate, the demand curve would shift to the right.  Interest rates would then rise and the quantity of loanable funds would increase. In addition, saving would increase as well.

11. Government Budget Deficits and Surpluses Policies  A budget deficit is an excess of government spending over tax revenue.  Governments finance deficits by borrowing in the bond market (the accumulation of past borrowing is our national debt).  A budget surplus can be used to pay down some of the debt.  When spending equals revenue, we have a balanced budget.

12.  What would happen if we ran a budget deficit?  A change in the government budget balance represents a change in public saving, and, therefore, in the supply of loanable funds.  When the government runs a deficit, then we have negative public savings. Thus, the supply curve would shift to the left as the supply of the funds would be reduced.  This would result in an increased interest rate and investment would fall.

13. Crowding Out  This fall in investment due to the government borrowing is known as a phenomenon called “crowding out”.  Government borrowing crowds out private investment.  This is one of the risks of expansionary fiscal policy.  Here’s what the CBO said about the stimulus plan in February:  http://www.washingtontimes.com/news/2009/feb/04/ cbo-obama-stimulus-harmful-over-long-haul/ http://www.washingtontimes.com/news/2009/feb/04/ cbo-obama-stimulus-harmful-over-long-haul/