The Loanable Funds Market Module 29

Matching Borrowers and Lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term In the Money Market, we looked at the supply and demand of liquid money The Fed will expand the money supply in the hopes of encouraging investment, thus increasing GDP HOWEVER making money available does not mean loans will be made

Matching Borrowers and Lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term In other words, simply having money available does not guarantee it will be invested Remember, in a simple economy Savings = Investment What makes people decide to save or borrow?

The Real Interest Rate 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term Since loans are for a certain duration, inflation becomes an important factor: Thus, we use the real interest rate when deciding whether to borrow or lend The Real Interest Rate = Nominal Interest Rate – Expected Inflation

Rate of Return 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term Potential borrowers will choose to invest if the rate of return of the proposed investment is greater than the real interest rate of the loan Rate of Return = (Revenue from Project – Costs from Project) × 100 Costs of Project

Demand for Loanable Funds 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term At low real interest rates, there will be many projects with rates of return that are higher. But at higher interest rates, fewer projects will qualify. Thus, as real interest rates decline, the quantity demanded of loanable funds increases.

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

Supply of Loanable Funds 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term A higher real interest rate means more people are convinced to save money rather than keep it liquid Thus, the supply of loanable funds is upward sloping

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

Market Equilibrium 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term At market equilibrium, the quantity of loanable funds supplied equals the quantity of loanable funds demanded The market matches projects that earn at or above this real interest rate with lenders that are willing to lend at that rate

Real Figure 29.3 Equilibrium in the Loanable Funds Market Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Shifts in Demand for Loanable Funds 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term Changes in perceived business opportunities Businesses might be in a rush to invest in order to adopt new technology or take advantage of new markets Changes in government borrowing Increased government borrowing increases the demand for loanable funds Crowding out

Real Figure 29.4 An Increase in the Demand for Loanable Funds Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Shifts in Supply of Loanable Funds 1) Matching borrowers and lenders - Saving and Investing - Real Interest Rate - Rate of Return 2) The Market for loanable funds - Demand - Supply - Equilibrium - Shifts 3) Short term v. Long term Changes in private savings behavior People will sometimes decide to save more (spend less), especially if they are uncertain about the future Changes in capital inflows Other countries want to invest in the United States If we become a more attractive place to invest, the supply of loanable funds will increase

Real Figure 29.5 An Increase in the Supply of Loanable Funds Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Problems For each of the following scenarios, use a correctly labeled graph to show how the market for loanable funds is affected. Show in your graph the impact on the equilibrium interest rate and quantity of loanable funds. Many businesses are convinced that artifical intelligence is the next big opportunity Households fear an imminent recession and begin to cut back on discretionary purchases.

The Federal government announces another annual budget surplus. Problems For each of the following scenarios, use a correctly labeled graph to show how the market for loanable funds is affected. Show in your graph the impact on the equilibrium interest rate and quantity of loanable funds. The Federal government announces another annual budget surplus. The flow of foreign financial capital into American financial markets begins to decrease.