The Loanable Funds theory

1
The Loanable Funds theory
We use the term loanable funds market to
describe the arrangements and institutions by
which saving of households is made available to
borrowers.
2
Factor income

1. Leakages must be recycled if total spending is to
   match full-employment GDP.
2. According to the Classical theory, the loanable
   funds market acts as a conduit to transfer
   spending power (S) from households to borrowing
   units (firms and government units).
3. Saving (S) is the source of loanable funds.

Consumption
Net taxes
Saving
3
Why do households save?
?

1. To have a more secure future, to start a
   business, to finance a childs education, to
   satisfy miserliness, . . .
2. To earn interest.

We view interest as the reward for saving or
the reward for postponing gratification.
4
The opportunity cost of spending now (measured in
lost future spending) is positively related to
the interest rate.
Value of 1,000 in 3 years at alternative
interest rates
5
Supply of Funds
Saving Supply of Funds
Interest rate
5
3
0
1.5
1.75
Trillions of Dollars
6
Why do firms borrow?

• To finance the acquisition of long-lived capital
  goods.
• The rate of interest is the cost of borrowing or
  the price of loanable funds.
• The investment demand curve indicates the level
  of investment spending at various interest rates.
• As the interest rate decreases, more investment
  projects become attractive in the assessment of
  business decision-makershence, the investment
  demand function is downward-sloping with respect
  to the interest rate.

7
Demand for Funds by Business
When the interest rate falls, investment spending
and the business borrowing needed to finance it
rises.
Interest rate
A
5
B
3
Investment Demand
0
1.5
Trillions of Dollars
1.0
8
Public sector borrowing

• Let G denote public sector (or government)
  spending for goods and services in a year
• T is net tax receipts in a year.
• If G is greater than T, the the public sector has
  a budget deficit equal to G T.
• If T is greater than G, then the public sector
  has a surplus equal to T G.
• If the public sector has a budget deficit, it
  must borrow.

9
Federal Government Budget Surplus (Deficit) in
billions , 1955-2000
www.economagic.com
10
Public Sector Borrowing in Classica
G 2 trillionT 1.25 trillionTherefore,
Budget Deficit G T 2 trillion - 1.25
trillion 0.75 trillion
Government Demand for Funds
5
B
Interest Rate
3
A
0.75
0
Trillions of Dollars
11
Demand for Loanable Funds (in Trillions)
12
Total Demand for Funds
Interest Rate
5
3
Trillions of Dollars
0
1.75
2.25
13
Loanable Funds Market Equilibrium
Total Supply of Funds (Saving)
Interest Rate
E
5
Total Demand for Funds (Investment Deficit)
0
Trillions of Dollars
1.75
14
Why does the loanable funds theory guarantee the
validity of Says law?
S IP G - T
Quantity of Funds Supplied
Quantity of Funds Demanded
Now, rearrange the equation above by bringing T
to the left side
S T IP G
Injections
Leakages
15
So long as the loanable funds market clears,
leakages (Saving) will be offset to injections
(investment and government spending).
16
Income (7 Trillion)
Income (7 Trillion)
Households
Consumption (4 Trillion)
Saving (1.75 Trillion)
Loanable Funds Markets
Net Taxes (1.25 Trillion)
Government Spending (2 Trillion)
Deficit (0.75 Trillion
Government
Resource Markets
GoodsMarkets
Investment (1 Trillion)
Firm Revenues (7 Trillion)
Firms
Factor Payments (7 Trillion)
17
Fiscal Policy
Changes in government spending, transfer
payments, and taxes designed to change total
spending in the economy and thereby influence
total output and employment.
18
The Classical view of Fiscal policy
Friends, we believe that fiscal policy is
unnecessary and ineffective. The economy is doing
just fine without meddling by Washington.
19
Crowding Out

• Crowding out is the idea that an increase in one
  component of spending will cause a decrease in
  other spending components.
• An increase in G may cause a decrease in C, IP,
  or boththat is, government spending may crowd
  out private spending.

20
Crowding Out With an Initial Budget Deficit
Total Supply of Funds (Saving)
B

• Increase in G AH
• Decrease in C AC
• Decrease in IP CH

7
A
C
Interest Rate
H
5
D2 IP G2 - T
D1 IP G1 - T
0
1.75
2.05
2.25
Trillions of Dollars
21
Effects of a Reduction in the Government Surplus
S2 Savings T G2
S1 Savings T G1
Interest Rate
B
7
H
C
A
5
D Investment
0
Trillions of Dollars
1.75
1.25
1.55