Market for Loanable Funds Crowding Out: What happens when a country’s debt gets too big?

Who are SAVERS in Economics? Who are INVESTORS in Economics? Consumers who have “extra money” They buy bonds, stocks, etc… to maintain/increase purchasing power Business who needs money to expand (I↑) They sell bonds, stocks, to expand business

Savers & Investors Loanable Funds is where savers & investors meet Savers buy securities (bonds) to earn interest Investors borrow money for capital investment Savers = Supply curve of loanable funds Private savings = Firms & households savings Public savings = government savings (it can be negative!) National Savings = Public & Private savings Investors = Demand curve for loanable funds (need to borrow money) Business demands loans for capital investment (“I” in GDP) Borrow $ & pay interest to savers

Loanable Funds Market Is an economic model of interest rates It is not the short term interest rate the Fed sets It is a “free market” longer term interest rate S & D determines this real interest rate It is meant to simulate “real” debt (bond) markets: Corporate Bonds, Mortgage Bonds etc…..

Shifting Loanable Funds Corporations become more confident about the economy Are they Supply or Demand in the loanable funds market? Business is the Demand Curve! Demand shifts right Business ↑ sales of Bonds => borrowing more money for capital investment (I)!

Theory of Crowding Out ↑ Government deficits shifts supply of loanable funds left National Savings falls public savings is more negative This leads to rising long-term interest rates Higher interest rates (r2) => a fall in business investment (I↓) Gov’t crowds out private borrowers (firms) who borrow less $ for capital goods (I) End Result: society has less capital investment. => in the long run, PPF curve will not shift to the right as far (less innovation, lower increase in full potential) --------- ------------- r2 Q2

Loanable Funds Handout