Investment Introduction to the Loanable Funds Market

Investment Investment (I) is a volatile component of GDP –Changes with level of interest rates Investment has 3 subcomponents: –New capital expenditure by firms –New housing expenditure by households –Net inventories Includes: Firm builds new plants Orders more machines/supplies Raises/lowers inventories Investment is fixed At a given level of interest rate GDP Investment Autonomous Investment IdId Interest Rate $ Investment

Deriving Savings GDP is both total income & total expenditure: Y = C + I + G + NX Assume a closed economy – (does not engage in foreign trade) Y = C + I + G Subtract C & G from both sides: Y – C – G = I

Derived Savings continued.. New Equation: Y – C – G = I This equals total income after paying for C & G Y – C – G is known as Savings (S) (what you don’t spend, you save) –the equation can be written as: S = I For the economy as a whole, savings must equal investment: { } Savings = Investment

National, Private & Public National Saving –Income that remains after paying for C + G –Equals Y – C – G Private Saving –Income that households have left after taxes & consumption –Equals Y – T – C (T=Taxes) –Public Saving –Amount of tax revenue government has left after spending –Equals T – G (T=Taxes)

LOANABLE FUNDS Financial markets coordinate the economy’s saving & investment in the market for loanable funds Supply of loanable funds: –Sum of private & public savings Demand for loanable funds: –households or firms that wish to invest

Loanable Funds (in billions of dollars) 0 Real Interest Rate Supply Demand 5% $1,200 Sum of Public & Private Savings Investment Demand

Real Interest Rate The price of the loan in real terms ( r ) –amount borrowers pay for loans & lenders receive on savings If real return on investment is > r, then make investment

Government Policies Gov’t Policies greatly affect Saving & Investment Gov’t Incentives: –Taxes on savings –Taxes on investment Size of Gov’t budget deficits or surplus

Example: Saving Incentives A tax decrease on savings Result: increases the incentive for households to save at any given interest rate –Supply of loanable funds curve shifts right –Equilibrium interest rate decreases –Quantity demanded for loanable funds increases

Changing Saving Incentives Loanable Funds (in billions of dollars) 0 Real Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600

Example: Investing Incentives A tax credit on investing –will increase the incentive to invest: Real Interest Rate Qty Loanable Funds D1D1 S1S i1i1 Q1Q1 E1E1 D Demand Increases Interest Rates rise

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