1. Loanable Fund and Exchange Markets
IMBA Macroeconomics III
Lecturer: Jack Wu

2. Recall GDP formula
Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:
Y = C + I + G + NX

3. Important identities
Assume a closed economy – one that does not engage in international trade:
Y = C + I + G
Now, subtract C and G from both sides of the equation:
Y – C – G =I
The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

4. Important identities: continued
Substituting S for Y - C - G, the equation can be written as:
S = I
National saving, or saving, is equal to:
S = Y – C – G
S = (Y – T – C) + (T – G)

5. Private saving = (Y – T – C)
Meaning of Saving
National Saving
National saving is the total income in the economy that remains after paying for consumption and government purchases.
Private Saving
Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.
Private saving = (Y – T – C)

6. Meaning of Saving: Continued
Public Saving
Public saving is the amount of tax revenue that the government has left after paying for its spending.
Public saving = (T – G)

7. Budget Surplus and Deficit
If T > G, the government runs a budget surplus because it receives more money than it spends.
The surplus of T - G represents public saving.
If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

8. Saving = Investment?
For the economy as a whole, saving must be equal to investment.
S = I

9. Market for Loanable Funds
Financial markets coordinate the economy’s saving and investment in the market for loanable funds.
The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.
Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

10. Supply and Demand for Loanable Funds
The supply of loanable funds comes from people who have extra income they want to save and lend out.
The demand for loanable funds comes from households and firms that wish to borrow to make investments.

11. Price of the Loan The interest rate is the price of the loan.
It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.
The interest rate in the market for loanable funds is the real interest rate.

12. Equilibrium
Financial markets work much like other markets in the economy.
The equilibrium of the supply and demand for loanable funds determines the real interest rate.

13. (in billions of dollars)
Interest
Rate
Supply
Demand 5%
$1,200
Loanable Funds
(in billions of dollars)
Copyright©2004 South-Western

14. Government Policies
Government Policies That Affect Saving and Investment
Taxes and saving
Taxes and investment
Government budget deficits

15. Saving Incentives: Tax Cut
Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.
A tax decrease increases the incentive for households to save at any given interest rate.
The supply of loanable funds curve shifts to the right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds increases.

16. . . . and raises the equilibrium quantity of loanable funds.
Interest
Supply, S1 S2
Rate
Demand
1. Tax incentives for
saving increase the
supply of loanable
fund
s . . . 5%
$1,200 2.
. . . which
reduces the
equilibrium
interest rat
e . . . 4%
$1,600
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

17. Investment Incentives: Investment Tax Credit
An investment tax credit increases the incentive to borrow.
Increases the demand for loanable funds.
Shifts the demand curve to the right.
Results in a higher interest rate and a greater quantity saved.

18. . . . and raises the equilibrium quantity of loanable funds.
Interest
Rate
Supply D2
1. An investment
tax credit
increases the
demand for
loanable fund
s . . .
Demand, D1 6%
$1,400 2.
. . . which
raises the
equilibrium
interest rate . . . 5%
$1,200
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

19. Government Budget Deficit
When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.
The accumulation of past budget deficits is called the government debt.

20. Crowding Out
Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms.
This fall in investment is referred to as crowding out.
The deficit borrowing crowds out private borrowers who are trying to finance investments.

21. Budget Deficit
A budget deficit decreases the supply of loanable funds.
Shifts the supply curve to the left.
Increases the equilibrium interest rate.
Reduces the equilibrium quantity of loanable funds.

22. . . . and reduces the equilibrium quantity of loanable funds.
Interest S2
Supply, S1
Rate
Demand
1. A budget deficit
decreases the
supply of loanable
fund
s . . .
$800 6% 2.
. . . which
raises the
equilibrium
interest rat
e . . .
$1,200 5%
Loanable Funds 3.
. . . and reduces the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

23. Net Capital Outflow
Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.

24. Variables influencing Net Capital Outflow
Variables that Influence Net Capital Outflow
The real interest rates being paid on foreign assets.
The real interest rates being paid on domestic assets.
The perceived economic and political risks of holding assets abroad.
The government policies that affect foreign ownership of domestic assets.

25. NX=NCO
Net exports (NX) and net capital outflow (NCO) are closely linked.
For an economy as a whole, NX and NCO must balance each other so that:
NCO = NX
This holds true because every transaction that affects one side must also affect the other side by the same amount.

26. National Saving = Investment + Net Capital Outflow
S=I + NCO
National saving is the income of the nation that is left after paying for current consumption and government purchases:
S=Y - C - G = I + NX
S=I + NCO
National Saving = Investment + Net Capital Outflow

27. Nominal Exchange Rate
The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.
The nominal exchange rate is expressed in two ways:
In units of foreign currency per one U.S. dollar.
And in units of U.S. dollars per one unit of the foreign currency.

28. Real Exchange Rate
The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.
The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.
If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

29. Formula

30. The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
real interest
rate
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning

31. Foreign-Currency Exchange Market
The two sides of the foreign-currency exchange market are represented by NCO and NX.
NCO represents the imbalance between the purchases and sales of capital assets.
NX represents the imbalance between exports and imports of goods and services

32. The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Demand for dollars
(for net exports)
Equilibrium
quantity
real exchange
rate
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning

33. Equilibrium in Open Economy
In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow.
In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports.

34. Equilibrium in Open Economy
Net capital outflow links the loanable funds market and the foreign-currency exchange market.
The key determinant of net capital outflow is the real interest rate.

35. How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
Net capital outflow
is positive.
Net Capital
Outflow
Copyright©2003 Southwestern/Thomson Learning

36. Equilibrium in Open Economy
Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

37. The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest
Interest
Net capital
outflow,
NCO
Supply
Rate
Rate
Demand r
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange
Supply
Rate
Demand E
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

38. Policies
The magnitude and variation in important macroeconomic variables depend on the following:
Government budget deficits
Trade policies
Political and economic stability

39. Government Budget Deficits
In an open economy, government budget deficits . . .
reduce the supply of loanable funds,
drive up the interest rate,
crowd out domestic investment,
cause net foreign investment to fall.

40. The Effects of Government Budget Deficit
1. A budget deficit reduces
the supply of loanable funds . . .
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest S S
Interest
Rate
Rate r2 B r2 E1 r A
which
increases
the real
interest
rate . . .
which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange S S
Rate
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . . E2
which
causes the
real exchange
rate to
appreciate.
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

41. Trade Policy
A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.
Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a good produced abroad and sold domestically.

42. The Effects of an Import Quota
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest
Supply
Interest
Rate
Rate r r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange
Supply
Rate D
1. An import
quota increases
the demand for
dollars . . . E2
and
causes the
real exchange
rate to
appreciate. E D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

43. Capital Flight
Capital flight is a large and sudden reduction in the demand for assets located in a country.
Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.
If investors become concerned about the safety of their investments, capital can quickly leave an economy.
Interest rates increase and the domestic currency depreciates.

44. The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
(b) Mexican Net Capital Outflow
Real
Real
Supply
NCO2
1. An increase
in net capital
outflow. . .
Interest
Interest
Rate D2
Rate r2
which
increases
the interest
rate. r1 r1
increases the demand
for loanable funds . . . D1
NCO1
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange S S2
Rate
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . . E
which
causes the
peso to
depreciate. E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning