1. Loanable Funds Market

2. 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/banks have chosen to save and lend out, rather than use for their own consumption.

3. Figure 1 The Market for Loanable Funds
Real Interest
Rate
Supply
Demand 5%
$1,200
Loanable Funds
(in billions of dollars)
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4. Supply and Demand for Loanable Funds
Supply = people, businesses, foreign citizens who have extra income they want to save and lend out.
Demand = households and firms that wish to borrow to make investments.
The interest rate in the market for loanable funds is the real interest rate. (This is a longer term market than the MM)

5. Government Policies That Affect Saving and Investment
Taxes and saving (SUPPLY)
Taxes and investment (DEMAND)
Government budget deficits (EITHER depending on approach)

6. Supply of Loanable Funds: Saving Incentives
Taxes on interest income 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.
If a change in tax law encourages greater saving, the result will be lower interest rates and greater quantity invested and vice versa

7. Figure 2 An Increase in the Supply 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

8. Demand for Loanable Funds: Investment Incentives
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.
If a change in tax laws encourages greater investment, the result will be higher interest rates and greater quantity saved and vice versa

9. Figure 3 An Increase in the Demand for 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

10. Differences in LFM and MM
Money Market
Loanable Funds
All money in economy (usually M2)
Affects nominal interest rates (fisher equation)
Supply controlled by FED
Demand mostly influenced by need for cash
Fiscal policies have little effect
ONLY money available for lending
Affects real interest rates
Supply controlled by private savings decisions
Demand mostly influenced by incentive to invest (I)
Fiscal policies have MAJOR effect (crowding out)

11. CROWDING OUT

12. Definition Crowding out occurs via the following sequence of events:
1. The government runs a deficit
2. To finance the deficit, government borrows money from private savings
3. The reduction in supply* of available savings drives interest rates higher
4. The higher interest rates decrease (CROWDS OUT) private investment, decreasing AD
* - Some argue it’s not the reduction in supply of available funds that drives up interest rates, but an increase in the number of DEMANDERS of loans. EITHER argument has the same effect!!!!!

13. Figure 4: The Effect of a Government Budget Deficit
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

14. 3 Possible options for crowding out
ZERO
PARTIAL
COMPLETE
LRAS
LRAS
LRAS PL PL PL
SRAS
SRAS
SRAS
AD2
AD2
AD3
AD1
AD1
AD1, AD2
RGDP
RGDP
RGDP

15. 3 Crowding Out Possibilities
ZERO: the higher interest rates do not change planned investment or consumption (unlikely) so AD1 fully corrects to AD2
PARTIAL: the increase in government spending is larger than the decrease in private investment, but not large enough to fully offset the decrease in Investment so AD1 increases to AD2, then falls to AD3
COMPLETE: the decrease in Investment is equal to or GREATER than the increase caused by the fiscal policy so AD1 does not correct or returns to it’s original location
May actually DECREASE!

16. Figure 5 The U.S. Government Debt
Percent
of GDP
120
World War II
100 80 60
Revolutionary
War
Civil
War
World War I 40 20
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
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