Loanable Funds market Framework This framework is particularly useful for predicting interest rate changes due to events in the country or the world. The analysis is conducted in terms of the price of money– interest rates– directly. No extra step is needed to relate the price of bonds (inversely) to the interest rate. GO to next

S tep 1: What is the thing? loanable funds Draw and LABEL the axis Q LF S tep 2: What is the PRICE of the thing? Draw and label the axis interest rate S tep 3: Who DEMANDS it? borrowers LIST all the factors that affect demand: expected income, expected inflation, gov’t deficit... S tep 4: From this initial i &Q, if the interest rate increased, would borrowers want more or less?... they’d want less S tep 5: connect those two points with the DEMAND curve label it 5. D LF by borrowers go to next Note that D LF by borrowers = S B

Q LF i List factors that affect supply: wealth, relative expected returns, relative risk, relative liquidity, expected inflation... D LF by borrowers (=S BONDS ) go to next Step 6: Who supplies it? savers Step 7: from an initial i,Q; if i increased, would savers provide less, or more...? they’d save more Step 8: draw the supply curve LABEL IT: Step 8. S LF by savers Note that S LF by savers = D BONDS

Q LF i D LF by borrowers go to next S LF by savers Step 9: identify the initial equilibrium interest rate (and quantity) ioio QoQo

Step 10. How does the event affect the factors of demand and supply? Example Event: What will happen to interest rates if people expect inflation to rise? DEMAND:if borrowers expect inflation to rise (later), they would rather buy more stuff now (to expand capacity, or whatever) so they would BORROW MORE NOW. D LF increases (= S BONDS increases). SUPPLY: if savers expect inflation to rise (later), they would rather buy more stuff now, so they would SAVE LESS NOW. SLF decreases (=D BONDS decreases). Now illustrate these effects on your graph, go to next S LF = f ( i ; W, e RET B / e RET oth,  B /  oth, l B /l oth, e  ) = D BONDS D LF = f ( i ; e GDP, gov’t deficit, e  ) = S BONDS

Q LF i D LF by borrowers go to next S LF by savers ioio QoQo Step 11. illustrate change (if any) in Demand D LF increases Step 12. illustrate change (if any) in Supply S LF decreases Step 13. identify the new equilibrium i i1i1

Q LF i D LF by borrowers S LF by savers ioio i1i1 Step 14. SUMMARIZE: If people expect inflation to rise, savers will supply fewer loans, because they would rather buy stuff now while prices are low. Borrowers will demand more loans so they can expand capacity and sell more stuff later when prices are higher. Interest rates will rise. back to Kilkenny’s 353 web page start over note: the change in the equilibrium quantity of loanable funds is not important in the analysis of interest rates.