WARM UP What is the difference between nominal and real interest rates?

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Is an interest rate of 50% good or bad? Bad for borrowers but good for lenders The loanable funds market brings together those who wish to borrow with those who want to lend Demand- Inverse relationship between real interest rate and quantity loans demanded Supply- Direct relationship between real interest rate and quantity loans supplied This is NOT the same as the money market. (supply is not vertical) 3

Remember: real interest rate =nominal interest rate-expected inflation If an investor locks in at 5% and the rate of inflation is 2% then the person is earning real interest rate of 3%. 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.

Which do we care about? Real Or Nominal?

Demand (comes from borrowers) is downward sloping because the lower the interest rate, the more firms want to borrow. Supply of loanable funds: comes from savers- is upward sloping.

Formula for loanable funds 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.

Loanable Funds (billions of dollars) Real Interest Rates % Supply of loanable funds Demand for loanable funds Equilibrium occurs when the quantity of loanable funds demanded equals the quantity supplied. r Q

Real Interest Rate 9 D Borrowers S Lenders Loanable Funds Market Quantity of Loans Q Loans D1D1 rere r1r1 Q1Q1 Example: The Gov’t increases deficit spending Government borrows from private sector Increasing the demand for loans Real interest rates increase causing crowding out!!

When Q dollars are lent and borrowed Investment spending projects with A rate of return of i r % or more Are funded and those where the Rate of return is less than i r are not Likewise, lenders who are willing To accept an interest rate of i r % Or less will have their offers to lend Funds accepted. Equilibrium interest rate at

Shifts of Demand for Loanable Funds Factors that can cause the demand curve for loanable funds to shift include: Changes in perceived business opportunities Changes in the government’s borrowing

Shifts in the supply of loanable funds occur as well. Factors that cause supply shifts are: Changes in private savings behavior Changes in capital inflows. Student Alert!! Anything that shifts either supply demand of loanable funds curve changes the interest rate.

15 (of 18)  Nominal Values  Values before an adjustment for inflation  The price stated in a contract  The actual price you will pay either now or later  Real Values  Values after an adjustment for inflation  ‘Constant’ dollars  Incorporates only productivity changes

The expected real interest rate is unaffected by the change in expected future inflation = lenders and borrowers base their decisions on the expected real interest rate Named after Irving Fisher.

E 0 S 0 D Q* Nominal Interest rate Quantity of loanable funds Demand for loanable funds at 0% expected inflation Demand for loanable funds at 10% expected inflation Supply of loanable funds at 10% expected inflation E 10 S D 14% Supply of loanable funds at 0% expected inflation 18 of 23

Figure Caption: Figure 29.6: The Fisher Effect D0 and S0 are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase in expected future inflation raises the equilibrium nominal interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged.

 When savers put savings in financial markets, they are lenders because those funds are lent to borrowers thru the banking system---Dollars saved/lent are = to dollars invested/borrowed  Demand for loanable funds comes from borrowers looking to make capital investments. If real interest rate falls, more investment projects become profitable, so more funds will be demanded. D m  Supply of loanable funds comes from savers looking to earn interest income. If Real interest rates rise-savers will forgo current consumption and save more money thus more funds will be supplied.

 Short-term vs. long –term decisions  FED determines money supply-it can put more money in the economy but they can’t control whether it is made available for loans.  People make those decisions based on the interest rate.  Thus the difference between the vertical MS curve and upward sloping supply of loanable funds.

 In the money market- we are concerned with short term decisions. “ how much money I need in my pocket to go shopping.”  Nominal interest rate is all that is relevant  In the long-term, there is likely to be inflation.  In the loanable funds market, we are looking at long term investments, “ How much do I need for retirement.”

2007B Practice FRQ (just do parts a and b) 25

2007B Practice FRQ 26

2007B Practice FRQ 27

2007B Practice FRQ: Just Do the Graph for (b) 28

2007B Practice FRQ 29