LOANABLE FUNDS MARKET

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LOANABLE FUNDS MARKET
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SUPPLY and DEMAND for LOANABLE FUNDS

• Saving is the source of the supply of loanable
  funds.
• -For example, when a household makes a
  deposit in a bank.
• Investment is the source of the demand of
  loanable funds.
• -For example, when households take out
  mortgages to buy homes. Or, when firms borrow
  to buy new capital equipment.

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• The interest rate is the price of a loan.
• A high interest rate makes borrowing more
  expensive, thus the quantity of loans demanded
  falls.
• Similarly, a high rate makes savings more
  attractive, and thus increases the amount of
  loanable funds supplied.

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• If the interest rate were lower than the
  equilibrium level, the quantity of loanable funds
  supplied would be less than the quantity
  demanded.
• The result is a shortage of funds, which would
  encourage lenders to raise the interest rate, and
  thereby increase saving and dissuade borrowing
  for investment.
• Conversely, if interest rates were higher than
  equilibrium, then the quantity of loans supplied
  would exceed those demanded.
• As lenders competed for scarce borrowers,
  interest rates would be driven down to reach
  equilibrium.

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• Remember, economists distinguish between nominal
  and real interest rates.
• The real interest rate is the nominal rate
  adjusted for inflation.
• Nominal rate Real interest rate Inflation
  Premium.
• Real interest rates more accurately reflect the
  real return. Therefore, the supply and demand
  for loanable funds depend on the real interest
  rate.

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Saving Incentives Policy

• American families save a smaller fraction of
  their incomes as compared to other industrialized
  countries, like Japan and Germany. (Note As of
  2009, this has changed somewhat due to the
  current recession. National Savings has
  increased.)
• However, the low savings rate might be due to tax
  policies in the U.S. Tax on interest income
  reduces incentives to save.

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• What if tax incentives were created for people to
  shelter some of their savings income? How would
  this impact the market for loanable funds?
• First, which curve would this policy affect?

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• Because the tax change would alter the incentive
  for households to save at any given interest
  rate, it would affect the quantity of loanable
  funds supplied at each interest rate.
• Therefore, the supply of funds would shift to the
  right.
• As a result, interest rates would be lower, and
  investment would increase.

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Investment Incentives Policy

• Suppose Congress decides to pass an investment
  tax credit to encourage firms to build new
  factories.
• As this is investment policy, it would affect
  demand. It would change the demand for loanable
  funds as firms are rewarded for borrowing and
  investing in new capital.

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• Next, since firms would have an incentive to
  increase investment at any interest rate, the
  demand curve would shift to the right.
• Interest rates would then rise and the quantity
  of loanable funds would increase. In addition,
  saving would increase as well.

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Government Budget Deficits and Surpluses Policies

• A budget deficit is an excess of government
  spending over tax revenue.
• Governments finance deficits by borrowing in the
  bond market (the accumulation of past borrowing
  is our national debt).
• A budget surplus can be used to pay down some of
  the debt.
• When spending equals revenue, we have a balanced
  budget.

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• What would happen if we ran a budget deficit?
• A change in the government budget balance
  represents a change in public saving, and,
  therefore, in the supply of loanable funds.
• When the government runs a deficit, then we have
  negative public savings. Thus, the supply curve
  would shift to the left as the supply of the
  funds would be reduced.
• This would result in an increased interest rate
  and investment would fall.

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Crowding Out

• This fall in investment due to the government
  borrowing is known as a phenomenon called
  crowding out.
• Government borrowing crowds out private
  investment.
• This is one of the risks of expansionary fiscal
  policy.
• Heres what the CBO said about the stimulus plan
  in February
• http//www.washingtontimes.com/news/2009/feb/04/cb
  o-obama-stimulus-harmful-over-long-haul/