Money Market and Loanable Funds Two Day Unit

Money Market Money supply (vertical) vs. money demanded (downward sloping) X-axis: Quantity of money Y-axis: Interest Rate There is one interest rate (your return on saving and the cost of borrowing)

Opportunity Cost of Holding Money What is the opportunity cost of holding money in currency and checking accounts???? You have $1000 Investment: High interest rate – 20% Low interest rate – 5% It costs you $200 a year to hold on to your money with a high interest rate Only $50 a year with a low interest rate

Money Market

Changes in money supply: MS Fed policy (expansionary vs. contractionary) Fractional Reserve Banking (reserve ratio) Includes: Currency and demand deposits (checking) MS is vertical and unresponsive to changes in the interest rate.

Changes in Money Demand: MD MD is the sum of the asset and transaction demand for money in a nation Inversely related to the interest rate The quantity of money demanded is higher when the interest rate is lower The quantity of oranges demanded is higher when the price of oranges is lower. Equilibrium nominal interest rate is found at the intersection of MS and MD.

Changes in nominal interest rate Anything that changes the supply or demand for money will lead to a change in the nominal interest rate. Example: Increase in GDP – lead to an increase in the transaction demand for money and shift MD to the right.

Assuming there is no change in the MS, interest rates will increase since banks - can charge a larger fee for the privilege of borrowing money - are willing to offer a greater rate to depositors who put their money in the bank Assuming there is no change in the MS, interest rates will increase since banks - can charge a larger fee for the privilege of borrowing money - are willing to offer a greater rate to depositors who put their money in the bank

What happens when... There is a decrease in GDP? - demand shift to left, decrease in interest rate An increase in MS? - supply will shift to right, decrease in IR A decrease in MS? - supply will shift to left, increase in IR A decrease in incomes? - demand will shift to left, decrease in IR

Draw a money market graph What will happen to the interest rate if – The Fed buys bonds on open market - Please show the shift on the graph What will happen to the interest rate if – The Fed buys bonds on open market - Please show the shift on the graph

Group Work: 2007 FRQ Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings. (a) Draw a correctly labeled graph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate

Loanable Funds Putting the FUN back in Loanable FUNds

The Loanable Funds Market Coordinates the economy’s saving, investments, and the flow of loanable funds abroad (net capital outflow) – Supply: income that people want to save (saving deposits) and lend out (buying bonds or stocks) – Demand: households and firms who wish to borrow to make investments (mortgages, building a new factory) Investment is the source of the demand for loanable funds – There is one interest rate (your return on saving and the cost of borrowing)

The Loanable Funds Market X-axis: Quantity of funds demanded for investment Y-axis: Real Interest Rate Demand for loanable funds (downward sloping) – Comes from I (investment) – Comes from Net capital outflow (NCO) Supply of loanable funds (upward sloping) – Comes from national savings (S)

What shifts the S and D for loanable funds?????? LFM Determinants While no specific determinants exist for the loanable funds market, there are several key changes to look for that may affect the market.

Shifts in Demand Demand (Investment) Economic Status – – Growth: Companies invest more and take out more loans. Thus, investment is high during economic growth. – Recession: companies refrain from expanding and lower investment. Government Incentives – Tax cut for growing businesses – When government incentives encourage higher investment, investment will increase.

Effect of Recession on Loanable Funds Market

Shifts in Supply (Savings) Trends – - Savings is directly affected by social trends. - Tough economic times, consumers might save more as a safeguard Foreign Markets – - If the U.S. economy were to have a higher interest rate than France, French citizens may choose to save their money in U.S. accounts. - Changes in foreign interest rates can directly affect savings in various economies.

Shifts in Supply: Increase in Savings

Draw a loanable funds market graph What will happen to the interest rate if the government takes away a tax break for start- up companies. Show the shift on a the graph.

Draw a loanable funds market graph Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase savings for retirement will affect the real market interest rate in the short run.

2009 FRQ Assume that the real interest rates in both Canada and India have been 5 percent. Now the real interest rate in India increases to 8 percent. Draw a graph of the loanable funds market in Canada, show how the increase in the real interest rate in India affects the real interest rate in Canada.