Module 29 The Market for Loanable Funds KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: What is the loanable funds market? The determinants of supply and demand in the loanable funds market How does “crowding out” relate to the loanable funds market and the AD/AS model? How does the money market and the loanable market relate in the short run?

Loanable Funds Market Demand is downward sloping for one very intuitive reason. Firms borrow to pay for capital investment projects. If the project has an expected rate of return that exceeds the real interest rate, the investment will be profitable, and the funds will be demanded.   Rate of return (%) = 100*(Revenue from project – Cost of project)/(Cost of project) As the real rate falls, more projects become profitable, so the quantity of funds demanded will increase. Real interest rate Supply is upward sloping. Savers can lend their money to borrowers, but in doing so must forgo consumption. In order to compensate for the forgone consumption, savers must receive interest income and as the real interest rate rises, the opportunity to earn more income rises, so more dollars will be saved. As the real rate rises, the quantity of funds supplied will increase.

Figure 29.1 The Demand for Loanable Funds Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 29.2 The Supply of Loanable Funds Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Shift of Demand for Loanable Funds Changes in perceived business opportunities (rate of return) Changes in government borrowing- leads to crowding out

Shift of Demand for Loanable Funds Changes in private saving behavior Changes in capital inflows

Inflation and Interest Rates Step 1: Expected inflation is 0% so real=nominal=5% in equilibrium at point A. Loanable funds are equal to F1 dollars. Step 2: Borrowers and lenders all expect inflation to be 5% into the future. Nominal = 10%, real = 5%.   The demand curve for funds shifts upward to D2: borrowers are now willing to borrow as much at a nominal interest rate of 10% as they were previously willing to borrow at 5%. That’s because with a 5% inflation rate, a 10% nominal interest rate corresponds to a 5% real interest rate. The supply curve of funds shifts upward to S2: lenders require a nominal interest rate of 10% to persuade them to lend as much as they would previously have lent at 5%. The new equilibrium is at point B. The result of an expected future inflation rate of 5% is that the equilibrium nominal interest rate rises from 5% to 10%.

Reconciling the Two Interest Rate Models: The Interest Rate in the Short Run Note: this is really best told as an intuitive story.   According to 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 leads to a rise in consumer spending and 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? According to the savings–investment spending identity, total savings in the economy is always equal to investment spending. Thus a fall in the interest rate leads to higher investment spending, and the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending. After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded.