KRUGMAN'SMACROECONOMICS for AP*

29

Margaret Ray and David Anderson

ModuleThe Marketfor Loanable Funds

What you will learnWhat you will learn

in thisin this ModuleModule::

• How the loanable funds market matches savers and investors

• The determinants of supply and demand in the loanable funds market

• How the two models of interest rates can be reconciled

The Market for Loanable FundsThe Market for Loanable Funds

•The Equilibrium Interest Rate

•Loanable Funds Market

•Nominal v. Real Interest Rate

•Rate of Return

•The laws of supply and demand explain the behavior of savers and borrowers

The Market for Loanable FundsThe Market for Loanable Funds

•Remember –

I = Private Savings + Public Savings + Capital Inflow

•Savers supply the S (lenders)

•Investors demand the D (borrowers)

•Loanable Fund Model used to determine the Equilibrium Real Interest Rate

•The laws of supply and demand explain the behavior of savers and borrowers

•Real Interest Rate (r) = nominal interest rate – expected inflation

Equilibrium in the LoanableEquilibrium in the Loanable Funds Market Funds Market

Real Interest Rate (r) = nominal interest rate – expected inflation

Funded projectsLend offers NOT accepted

Unfunded projectsLend offers accepted

Shifts of the Demand forShifts of the Demand for Loanable Funds Loanable Funds

• ∆ Perceived Business Opportunities• Growing economy = right shift

• Recession = left shift

Shifts of the Demand forShifts of the Demand for Loanable Funds Loanable Funds

• ∆ Government Borrowing• Budget deficit = more borrowing = right shift

• Budget surplus = less debt so less borrowing = left shift

Shifts of the Demand forShifts of the Demand for Loanable Funds Loanable Funds

• Crowding OutHigher Interest rates will

cause some investment to be ‘crowded out’ by the government’s demand for loadable funds.

Shifts of the Supply of LoanableShifts of the Supply of Loanable Funds Funds

• ∆ Private Savings Behavior

• Consume more = save less = left shift

Shifts of the Supply of LoanableShifts of the Supply of Loanable Funds Funds

• ∆ Capital Inflows

• A nation is perceived to have a stable government, strong economy, a good place to save money.

• Foreign $$$ will flow into nation’s financial market, increasing the S of loadable funds.

Inflation and Interest RatesInflation and Interest Rates

•Anything that shifts either the S or D for loanable funds changes the interest rate.

•Borrowers – true cost of borrowing is the real interest rate

•Lenders – true payoff of lending is the real interest rate

Inflation and Interest RatesInflation and Interest Rates

•The Fisher Effect• As long as the Level of Inflation is Expected

• NO affect on• Equilibrium Q of loanable funds• Expected real interest rate

• Yes affect on nominal interest rate

This

Inflation and Interest RatesInflation and Interest Rates

This graph shows that the only thing rising is the Nominal Interest Rate.

Equilibrium Q Is the same.

D and S for Loanable funds Will be at EquilibriumAt the higher Nominal interest rate.

Reconciling the Two Interest Rate Models:Reconciling the Two Interest Rate Models: The Interest Rate in the Short Run The Interest Rate in the Short Run

Reconciling the Two Interest Rate Models: Reconciling the Two Interest Rate Models: The Interest Rate in the Long RunThe Interest Rate in the Long Run

Graph PracticeGraph Practice

Use a correctly labeled graph to show how the market for loanable funds is affected. Show in your graph the impact on the equilibrium interest rate and Q of loanable funds.

1. The chair of the Federal Reserve testifies before Congress that he/she expects the health of the economy to significantly improve in the coming months.

2. Households fear an imminent recession and begin to cut bank on discretionary purchases.

3. The Federal government announces another annual budget surplus.

4. The flow of foreign financial capital into American financial markets begins to decrease.