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

What you will learn in this Module: How the loanable funds market matches savers and investors The determinants of supply and demand in the loanable funds market How the two models of interest rates can be reconciled

The Market for Loanable Funds The Equilibrium Interest Rate Loanable Funds Market Nominal v. Real Interest Rate Rate of Return The laws of supply and demand explain the behavior of savers and borrowers Note: it will be important for students to be reminded of the savings-investment identity from earlier modules.   Closed economy: S = I Add the public sector (government): National savings = private savings + public savings = I Add the foreign sector: National savings + capital inflow = I It is through the financial markets by which the funds of the savers are borrowed by investors. Economists use the model of a market for loanable funds to explain these interactions and determine the equilibrium real interest rate. A. The Equilibrium Interest Rate Economists work with a simplified model in which they assume that there is just one market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects). This hypothetical market is known as the loanable funds market. The price that is determined in the loanable funds market is the interest rate, denoted by r. Note: the instructor should spend a little time pointing out to the students that the interest rate on the vertical axis represents the real interest rate, not the nominal. Recent scoring of the AP Macro free-response questions require an accurate labeling of this vertical axis. Savers and borrowers care about the real interest rate because that is what they earn or pay after inflation. Real interest rate = nominal interest rate – expected inflation If expected inflation =0%, then: real rate = nominal rate. But it’s also true that if expected inflation is constant, any change in the nominal rate will be reflected in an identical change in the real rate. This is why the graphs in the text are labeled “nominal interest rate for a given expected future inflation rate.” Note: for the reasons explained above, it is important, and accurate, to get the students in the habit of labeling this vertical axis as “real interest rate” or “r”.

Equilibrium in the 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.

Shifts of the Demand for Loanable Funds The factors that can cause the demand curve for loanable funds to shift include the following: Changes in perceived business opportunities:   A change in beliefs about the rate of return on investment spending can increase or reduce the amount of desired spending at any given interest rate. If firms believe that the economy is ripe with profitable investment opportunities, the demand for loanable funds will increase. If firms believe the economy is poised for a recession where profitable investment opportunities will be few and far between, the demand will decrease. Changes in the government’s borrowing: Governments that run budget deficits are major sources of the demand for loanable funds. When the government runs a budget deficit, the Treasury must borrow funds and acquire more debt. This increases the demand for loanable funds in the market. If the government were to run a budget surplus, less debt would be required and the demand for loanable funds would decrease. Note: show the impact of both an increase, and then a decrease, in the demand for loanable funds. ∆ Perceived Business Opportunities ∆ Government Borrowing Crowding-Out

Shifts of the Supply of Loanable Funds Among the factors that can cause the supply of loanable funds to shift are the following:   Changes in private savings behavior: If households decide to consume more and save less, the supply of loanable funds will shift to the left. Changes in capital inflows: For a variety of economic and political reasons, a nation may receive more capital inflow in a given year. If a nation is perceived to have a stable government, a strong economy and is a good place to save money, foreign money will flow into that nation’s financial markets, increasing the supply of loanable funds. Note: show the impact of both an increase, and then a decrease, in the supply of loanable funds. ∆ Private Savings Behavior ∆ Capital Inflows

Inflation and Interest Rates Real Interest = Nominal Interest - Inflation r% = i% - π% The Fisher Effect Nominal Interest = Real Interest + Expected Inflation i% = r% + exp. π% Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate.   We have seen in previous modules that unexpected inflation creates winners and losers, particularly among borrowers and lenders. Economists capture the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the difference is as follows: Real interest rate = Nominal interest rate — Inflation rate For borrowers, the true cost of borrowing is the real interest rate, not the nominal interest rate. For lenders, the true payoff to lending is the real interest rate, not the nominal interest rate. Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): the expected real interest rate is unaffected by the change in expected future inflation. The Fisher effect says that an increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point. The central point is that both lenders and borrowers base their decisions on the expected real interest rate. As long as the level of inflation is expected, it does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.

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.

Reconciling the Two Interest Rate Models: The Interest Rate in the Long Run In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate.   Why not? Both the money market and loanable funds markets are in equilibrium. Now suppose the money supply rises from 1 to 2. This initially reduces the interest rate to r2. In the long run the aggregate price level will rise by the same proportion as the increase in the money supply (due to the neutrality of money, a topic presented in detail in the next section). A rise in the aggregate price level increases money demand in the same proportion. So in the long run the money demand curve shifts out to MD2, and the equilibrium interest rate rises back to its original level, r1. What about the loanable funds market? An increase in the money supply leads to a short­ -­ run rise in real GDP and that this shifts the supply of loanable funds rightward from S1 to S2. In the long run, real GDP falls back to its original level as wages and other nominal prices rise. As a result, the supply of loanable funds, S, which initially shifted from S1 to S2, shifts back to S1. In the long run, then, changes in the money supply do not affect the interest rate. In the long run, the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output.