1. FINANCE,SAVING, & INVESTMENT
Financial Terms and markets
Loanable Funds Market
Government Deficit and Surplus Impact on Real Interest Rate and Loanable Funds

2. Financial Institutions and Markets
Some financial definitions:
Finance: the lending and borrowing of money
Capital: the tools, instruments, machines, buildings, and other constructions that have been produced in the past and that are used to produce goods and services. This is also called physical capital
Financial Capital: the funds that firms use to buy and operate physical capital.

3. Financial Definitions, cont’d.
Investment, Wealth, Saving
Investment: increases the quantity of capital.
Depreciation: decrease the quantity of capital.
Gross Investment: total amount spent on new capital
Net Investment: The change in quantity of capital. Takes depreciation into effect.
Net Investment =
gross investment – depreciation

4. GROSS AND NET INVESTMENT
Figure 25.1 illustrates the relationship between capital and investment.
On January 1, 2008,Tom’s DVD
Burning, Inc. had DVD recording
machines valued at $30,000.

5. GROSS AND NET INVESTMENT
During 2010, the value of Tom’s machines fell by $20,000, depreciation.
During 2010, Tom’s spent $30,000 on new machines—gross
investment.
Tom’s net investment was $10,000, so at the end of 2010,Tom had capital valued at $40,000.

6. Financial Definitions, cont’d.
Wealth: the value of all the things that a person owns. Income is not wealth.
Saving: the amount of income that is not paid in taxes or spent on consumption goods and services; saving adds to wealth.
To make real GDP grow saving and wealth must be transformed into investment and capital. This takes place in markets for financial capital.

7. Markets for Financial Capital
Markets for Financial Capital (the funds used to purchase physical capital): Loan Markets, Bond Markets, Stock Markets. Remember, a market has both suppliers and demanders
Loan Markets
Businesses often want short-term loans to buy inventories or to extend credit to their customers.
Households often want funds to purchase big-ticket items, such as automobiles or household furnishings and appliances.
Sometimes they get these funds in the form of a loan from a bank. Many times it is in the form of credit card balances.

8. Markets for Financial Capital
Bond market is a financial market in which bonds issued by firms and governments are traded.
Bond is a promise to pay specified sums of money on specified dates; it is a debt for the issuer.
The term of a bond might be long (decades) or short (just a month or two).
Stock market is a financial market in which shares of companies’ stocks are traded.
Stock is a certificate of ownership and claim to the profits that a firm makes.
Stocks, bonds, and loans are collectively called financial assets.

9. FINANCIAL INSTITUTIONS AND MARKETS
A financial institution is a firm that operates on both sides the markets for financial capital: It borrows in one market and lends in another. In other words it supplies and demands
The key financial institutions are :
Investment banks
Commercial banks
Government-sponsored mortgage lenders – FannieMae/FreddieMac
Pension funds
Insurance companies

10. THE MARKET FOR LOANABLE FUNDS
Flows in the Market for Loanable Funds
Loanable funds are used for (demand)
1. Business investment
2. Government budget deficit
3. International investment or lending
Loanable funds come from (supply)
1. Private saving
2. Government budget surplus
3. International borrowing

11. Loanable Funds
The market for loanable funds is the aggregate of the markets for loans, bonds, and stocks.
In the market for loanable funds there is just one average interest rate which we refer to as the interest rate.
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period.
Investment is the major item that influences the demand side of the market for loanable funds.

12. Interest Rates and Qd of LF
Investment depends on two things:
The Real Interest Rate
Expected Profit
So firms compare the real interest rate with the rate of profit that they expect to earn on their new capital.
Firms invest only when they expect to earn a rate of profit that exceeds the real interest rate.
The higher the real interest rate, the fewer projects that are profitable, so the smaller is the quantity of loanable funds demanded.

13. DEMAND FOR LOANABLE FUNDS
1. A rise in the real interest rate decreases the quantity of loanable funds demanded.
2. A fall in the real interest rate increases the quantity of loanable funds demanded.

14. Determinants of Demand for Loanable Funds – Shift the Curve
When the expected profit changes, the demand for loanable funds changes. We see a change in business investment.
The are four main determinants of the Demand for the Loanable Funds Market
Phase of the business cycle
Technological change
Population growth
Expectations (institutions about the market). These are subjective influences and contagion summarized in the phrases “animal spirits” (Keynes) and “irrational exuberance” (Greenspan). Essentially just swings of optimism and pessimism.

15. DEMAND FOR LOANABLE FUNDS
This figure shows:
1. An increase in expected profit increases investment and shifts the demand for loanable funds curve rightward to DLF1.
2. A decrease in expected profit decreases investment and shifts the demand for loanable funds curve leftward to DLF2.

16. Shifts in the LF Demand Curve
Increase in Government Borrowing
When the government runs a deficit, it must borrow funds to pay for some of its spending. This will also causes an increase in the demand for loanable funds.
“Crowding out Effect” – When the government borrows money in the loanable funds market it crowds out private borrowing: households, businesses, foreign investment.

17. Crowding Out

18. Supply of Loanable Funds
The quantity of loanable funds supplied is the aggregate funds available from private saving, the government budget surplus, and international borrowing during a given period.
The higher the real interest rate, the greater the amount of saving, the greater the quantity of loanable funds supplied
Saving is the main item and it depends on:
The real interest rate
Disposable income
Wealth
Expected future income
Default risk

19. Supply for Loanable Funds
1. A rise in the real interest rate increases the quantity of loanable funds supplied.
2. A fall in the real interest rate decreases the quantity of loanable funds supplied. – WHY?

20. Determinants of the Supply of Loanable Funds – What shifts the Curve?
The four main factors that influence saving and change the supply of loanable funds are:
1. Disposable income
2. Wealth
3. Expected future income
4. Default risk
Beyond these 4 influences on savings, an increase in the money supply (money market) can also impact the supply of loanable funds.

21. Impacts on Saving – Change in Supply of LF
Other things remaining the same (ceteris paribus),
The greater a household’s disposable income, the greater is its saving.
The greater a household’s wealth (what it owns), the less it will save.
The higher a household’s expected future income, the smaller is its saving today.

22. Changes in Money Supply – Change in Supply of LF
Increase in the money supply decrease short-term interest rates and increases the supply of loanable funds, decreasing long term interest rates.
As National income (Y) increases, savings increases shifting the supply curve in loanable funds to the right (increase).
Many financial institutions will also take advantage of the lower short-term interest rates. This increases supply in LF market.

23. Change in Supply of LF
The figure shows a change in the supply of loanable funds.
1. The supply of loanable funds curve shifts rightward from SLF0 to SLF1 if
Disposable income increases.
Wealth, expected future income, or default risk decreases.
Money Supply increases

24. Equilibrium in the Market for Loanable Funds
1. If the real interest rate is 8 percent a year, the quantity demanded is less than the quantity supplied. There is a surplus of funds. The real interest rate falls.
2. If the real interest rate is 4 percent a year, the quantity demanded exceeds the quantity supplied. There is a shortage of funds. The real interest rate rises.

25. Equilibrium in the Market for Loanable Funds
3. When the real interest rate is 6 percent a year, the quantity of loanable funds demanded equals the quantity supplied.
There is neither a shortage nor a surplus of funds, and the real interest rate is at its equilibrium level.

26. THE MARKET FOR LOANABLE FUNDS
Changes in Demand and Supply
1. If the demand for loanable funds increases, the real interest rate rises.
2. If the supply of loanable funds increases, the real interest rate falls.
Students usually have many questions about the role of the government and the potential dangers of high budget deficits that they may have heard about on the news or in discussions at home. You might take this opportunity to discuss budget deficits in greater detail. Use the material on the Ricardo-Barro effect versus crowding out to highlight some of the controversy in the politics of budget deficits. Students can then see how the application of economic models may still lead individuals to different conclusions. You may wish to tie this to current political discussions regarding budget deficits (and specific funding requests by the government) and the effects on the economy.

27. Government: Surplus v. Deficit
A government budget surplus increases the supply of loanable funds.
An increase in the supply of loanable funds brings a lower real interest rate, which decreases the quantity of private funds supplied and increases the quantity of investment and the quantity of loanable funds demanded.
A government budget deficit increases the demand for loanable funds.
But the higher interest rate decreases investment and the quantity of loanable funds demanded by firms to finance investment.

28. Crowding Out
The tendency for a government budget deficit to raise the real interest rate and decrease investment is called the crowding-out effect.
Since interest rates rise, savings increase, and less private sector investment takes place. They are “crowded out” of the market place.

29. Stossel – Government Spending

30. GOVERNMENT IN LOANABLE FUNDS MARKET
The figure shows the effects of government budget surplus.
With balanced government budgets, the real interest rate is 6 percent a year and the quantity of loanable funds is $2 trillion a year.
1. A government budget surplus of $1 trillion is added to private saving to determine the supply of loanable funds curve SLF.

31. GOVERNMENT IN LOANABLE FUNDS MARKET
2. The real interest rate falls to 4 percent a year.
3. The private supply of funds decreases to $1.5 trillion.
4. The quantity of loanable funds demanded and investment increase to $2.5 trillion.

32. GOVERNMENT IN LOANABLE FUNDS MARKET
The shows the effects of government budget deficit.
With balanced government budgets, the real interest rate is 6 percent a year and the quantity of loanable funds is $2 trillion a year.
1. A government budget deficit of $1 trillion is added to the private demand to determine the demand for loanable funds curve DLF.

33. GOVERNMENT IN LOANABLE FUNDS MARKET
2. The real interest rate rises to 8 percent a year.
3. The supply of loanable funds increases to $2.5 trillion.
4. The quantity of loanable funds demanded and investment decrease to $1.5 trillion.
Investment is crowded out.