Loanable Fund and Exchange Markets IMBA Macroeconomics III Lecturer: Jack Wu

Recall GDP formula Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX

Important identities Assume a closed economy – one that does not engage in international trade: Y = C + I + G Now, subtract C and G from both sides of the equation: Y – C – G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Important identities: continued Substituting S for Y - C - G, the equation can be written as: S = I National saving, or saving, is equal to: S = Y – C – G S = (Y – T – C) + (T – G)

Private saving = (Y – T – C) Meaning of Saving National Saving National saving is the total income in the economy that remains after paying for consumption and government purchases. Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C)

Meaning of Saving: Continued Public Saving Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

Budget Surplus and Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

Saving = Investment? For the economy as a whole, saving must be equal to investment. S = I

Market for Loanable Funds Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Price of the Loan The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate.

Equilibrium Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

(in billions of dollars) Interest Rate Supply Demand 5% $1,200 Loanable Funds (in billions of dollars) Copyright©2004 South-Western

Government Policies Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits

Saving Incentives: Tax Cut Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

. . . and raises the equilibrium quantity of loanable funds. Interest Supply, S1 S2 Rate Demand 1. Tax incentives for saving increase the supply of loanable fund s . . . 5% $1,200 2. . . . which reduces the equilibrium interest rat e . . . 4% $1,600 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Investment Incentives: Investment Tax Credit An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.

. . . and raises the equilibrium quantity of loanable funds. Interest Rate Supply D2 1. An investment tax credit increases the demand for loanable fund s . . . Demand, D1 6% $1,400 2. . . . which raises the equilibrium interest rate . . . 5% $1,200 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Government Budget Deficit When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

Crowding Out Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments.

Budget Deficit A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

. . . and reduces the equilibrium quantity of loanable funds. Interest S2 Supply, S1 Rate Demand 1. A budget deficit decreases the supply of loanable fund s . . . $800 6% 2. . . . which raises the equilibrium interest rat e . . . $1,200 5% Loanable Funds 3. . . . and reduces the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Net Capital Outflow Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.

Variables influencing Net Capital Outflow Variables that Influence Net Capital Outflow The real interest rates being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign ownership of domestic assets.

NX=NCO Net exports (NX) and net capital outflow (NCO) are closely linked. For an economy as a whole, NX and NCO must balance each other so that: NCO = NX This holds true because every transaction that affects one side must also affect the other side by the same amount.

National Saving = Investment + Net Capital Outflow S=I + NCO National saving is the income of the nation that is left after paying for current consumption and government purchases: S=Y - C - G = I + NX S=I + NCO National Saving = Investment + Net Capital Outflow

Nominal Exchange Rate The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The nominal exchange rate is expressed in two ways: In units of foreign currency per one U.S. dollar. And in units of U.S. dollars per one unit of the foreign currency.

Real Exchange Rate The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

Formula

The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity real interest rate Quantity of Loanable Funds Copyright©2003 Southwestern/Thomson Learning

Foreign-Currency Exchange Market The two sides of the foreign-currency exchange market are represented by NCO and NX. NCO represents the imbalance between the purchases and sales of capital assets. NX represents the imbalance between exports and imports of goods and services

The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity real exchange rate Quantity of Dollars Exchanged into Foreign Currency Copyright©2003 Southwestern/Thomson Learning

Equilibrium in Open Economy In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow. In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports.

Equilibrium in Open Economy Net capital outflow links the loanable funds market and the foreign-currency exchange market. The key determinant of net capital outflow is the real interest rate.

How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net capital outflow is negative. Net capital outflow is positive. Net Capital Outflow Copyright©2003 Southwestern/Thomson Learning

Equilibrium in Open Economy Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets. As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

The Real Equilibrium in an Open Economy (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Interest Net capital outflow, NCO Supply Rate Rate Demand r Quantity of Net Capital Loanable Funds Outflow Real Exchange Supply Rate Demand E Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Policies The magnitude and variation in important macroeconomic variables depend on the following: Government budget deficits Trade policies Political and economic stability

Government Budget Deficits In an open economy, government budget deficits . . . reduce the supply of loanable funds, drive up the interest rate, crowd out domestic investment, cause net foreign investment to fall.

The Effects of Government Budget Deficit 1. A budget deficit reduces the supply of loanable funds . . . (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest S S Interest Rate Rate r2 B r2 E1 r A 2. . . . which increases the real interest rate . . . 3. . . . which in turn reduces net capital outflow. Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Exchange S S Rate 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . E2 5. . . . which causes the real exchange rate to appreciate. Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Trade Policy A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Tariff: A tax on an imported good. Import quota: A limit on the quantity of a good produced abroad and sold domestically.

The Effects of an Import Quota (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Supply Interest Rate Rate r r 3. Net exports, however, remain the same. Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Exchange Supply Rate D 1. An import quota increases the demand for dollars . . . E2 2. . . . and causes the real exchange rate to appreciate. E D Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Capital Flight Capital flight is a large and sudden reduction in the demand for assets located in a country. Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. If investors become concerned about the safety of their investments, capital can quickly leave an economy. Interest rates increase and the domestic currency depreciates.

The Effects of Capital Flight (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Real Supply NCO2 1. An increase in net capital outflow. . . Interest Interest Rate D2 Rate r2 3. . . . which increases the interest rate. r1 r1 2. . . . increases the demand for loanable funds . . . D1 NCO1 Quantity of Net Capital Loanable Funds Outflow Real Exchange S S2 Rate 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . E 5. . . . which causes the peso to depreciate. E Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning