1. The Loanable Funds Market

2. Equilibrium Interest Rate
Savers and borrowers are matched in markets governed by supply and demand
There are many markets, but economists view them as one – the loanable funds market
The price determined in the loanable funds market is the real interest rate, r
There are a large number of different financial markets, but economists simplify the model that brings together those who want to led money (savers) and those who want to borrow (firms with investment spending projects).This hypothetical market is known as the loanable funds market.
Price is r. It is the return a lender receives for allowing borrowers the use of a dollar for one year, calculated as a percentage of the amount borrowed.
In reality, neither borrowers nor lenders know what the future inflation rate will be when they make a deal, so actual loan contracts specify a nominal interest rate, rather than a real interest rate.

3. Demand for Loanable Funds
Firms are the Demanders! (borrowers)
Slopes downward because businesses decide whether to borrow based on rate of return
Rate of return =
Revenue from project – Cost of project  100
Cost of project
The lower the interest rate, the larger quantity of loanable funds demanded
How does a given business decide whether or not to borrow money to finance a project? The decision depends on the interest rate the business faces and the rate of return on its project—the profit earned in the project expressed as a percentage of its cost. Recall the rate of return formula.
Here, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion.

4. Supply of Loanable Funds
Households are the Suppliers! (lenders)
Slopes upward because lenders are more willing to forego immediate use of their money when the profit is greater.
The supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. Here, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion.

5. Equilibrium Interest Rate
Equilibrium interest rate, re, is the rate at which quantity supplied = quantity demanded
Creates efficiency, more profitable projects are funded AND lenders with more reasonable rates receive business
leads to greater long-run economic growth
At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here, the equilibrium interest rate is 8%, with $300 billion of funds lent and borrowed. Investment spending projects with a rate of return of 8% or higher receive funding; those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not.

6. Shifts of Demand for Loanable Funds
Changes in perceived business opportunities (and the potential rate of return) can increase/decrease the amount of desired spending.
Changes in government borrowing (i.e., in times of deficit) can create significant changes in demand for funding.
*A major concern of budget deficit is
that it raises interest rates, leading to
lower business investment spending.
Economists call the negative effect of
budget deficits on investment
spending crowding out.
For example, during the 1990s there was a great excitement over the business possibilities created by the internet. As a result, businesses rushed to buy computer equipment, shifting demand of loanable funds to the right.
For example, in 2000, the federal government was actually providing loanable funds to the market because it was paying off some of its debt shifting D of LF to left. This ended in 2003 when the government had to borrow large sums to pay the bills shifting D of LF back to the right.
If the quantity of funds demanded by borrowers rises at any given interest rate, the demand for loanable funds shifts rightward from D1 to D2. As a result, the equilibrium interest rate rises from r1 to r2.

7. Shifts of Supply of Loanable Funds
Changes in private savings behavior make greater/fewer loanable funds available.
Changes in capital inflows as a result of changes in the perceived safety of investing in a country will also alter availability of funding.
A number of factors can cause the level of private saving to change at any given rate of interest. For ex, between 2000 and 2006 rising home prices in the US made many homeowners feel richer, making them willing to spend more and save less, shifting SLF to the left.
US receives a large capital flow which fuels a big increase in investment spending.

8. Inflation and Interest Rates
Changes in expectations about inflation can shift both supply and demand for loanable funds
The true cost of borrowing/payoff of lending is the REAL interest rate, not nominal
Real interest rate = nominal interest rate – inflation rate
Expectations about inflation rates are based on recent experience, so interest rates lag behind true inflation trends
To see why, suppose a firm borrows $10,000 for one year at a 10% nominal interest rate. At the end of the year, it must repay $11,000—the amount borrowed plus the interest. But suppose that over the course of the year the average level of prices increased by 10%, so that the real interest rate is zero. Then the $11,000 repayment has the same purchasing power as the original $10,000 loan. In effect, the borrower has received a zero-interest loan.
Similarly, the true payoff to lending is the real interest rate, not the nominal rate. Suppose that a bank makes $10,000 loan for one year at a 10% minimal interest rate. At the end of the year, the bank receives an $11,000 payment. But if the average level of prices rises by 10% per year, the purchasing power of the money the bank gets back is no more than that of the money it lent out. In effect, the bank has made a zero-interest loan.

9. Fisher Effect
The Fisher effect states that expected real interest rate is unaffected by changes in expected future inflation. Only nominal interest rate is affected. Let’s graph this…
Do and So 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.

10. Reconciling the 2 Interest Rate Models
In the liquidity preference model of the interest rate, we stated that i is the rate at which MD = MS.
In the loanable funds model, r is the rate at which demand for loanable funds = supply of loanable funds.

11. Interest Rate in the Short Run
In the liquidity preference model, decreased interest leads to a rise in investment spending, and a resulting rise in GDP and consumer spending.
That means there is a corresponding rise in savings, increasing the supply of loanable funds and increasing investment spending.
The interest rate in the money market and loanable funds market is always the same. In the short run, money market events drive r and impact the loanable funds market.

12. Short-Run Determination of the Interest Rate

13. Interest Rate in the Long Run
In the long run, changes in the money supply don’t affect the interest rate
In the long run, an increase in the money supply causes an equal increase in price levels, so there would be a rightward shift in MD – raising the interest rate back to equilibrium
This is the result of a shift in supply in the loanable funds market, as prices rise.
In the long run, the loanable funds market determines r, as it is the level at which supply meets demand for loanable funds – which meets potential output.

14. Long-Run Determination of the Interest Rate