1. THE MARKET FOR LOANABLE
FUNDS
MODULE 29

2. FINANCIAL MARKETS
• . . . are the markets in the economy that help
to match one person’s saving with another
person’s investment.
• . . . move the economy’s scarce resources from
savers to borrowers.
• . . . are opportunities for savers to channel
unspent funds into the hands of borrowers.

3. FINANCIAL INSTITUTIONS
• Institutions that allow savers and borrowers to
interact are called financial intermediaries.
• Types of Financial Intermediaries:
• Banks - Bond Market
• Stock Market - Mutual Funds
• Other

4. BANKS
• Banks take in deposits from people who want
to save and make loans to people who want to
borrow.
• Banks pay depositors interest and charge
borrowers higher interest on their loans.
• Banks help create a medium of exchange, by
allowing people to write checks against their
deposits.

5. THE BOND MARKET
• A bond is a certificate of indebtedness that
specifies obligations of the borrower to the
holder of the bond.
• Characteristics of a bond:
• Term: the length of time until maturity.
• Credit Risk: the probability that the borrower will
fail to pay some of the interest or principle.
• Tax Treatment: municipal bonds on which taxes
are deferred on the interest.

6. THE STOCK MARKET
• Stock represents ownership in a firm, thus the
owner has claim to the profits that the firm
makes.
• Sale of stock infers “equity finance” but offers
both higher risk and potentially higher return.
• Markets in which stock is traded:
• New York Stock Exchange
• American Stock Exchange
• NASDAQ

7. MUTUAL FUNDS
• Mutual Funds is an institution that sells shares
to the public and uses the proceeds to buy a
selection, or portfolio, of various types of
stocks, bonds, or both.
• Allows people with small amounts of money
to diversify.

8. OTHERS
• Other financial intermediaries include:
• Savings and Loans Associations
• Credit Unions
• Pension Funds
• Insurance Companies
• Loan Sharks

9. SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• Recall: GDP is both total income in an
economy and the total expenditure on the
economy’s output of goods and services:
• Y = C + I + G + NX
• Assume a closed economy:
• Y=C+I+G
• National Saving or Saving is equal to:
• Y-C-G=I=S

10. SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• National Saving or Saving is equal to:
• Y - C - G = I = S or
• S = (Y - T - C) + (T - G)
• where “T” = taxes net of transfers
• Two components of national saving:
• Private Saving = (Y - T - C)
• Public Saving = (T - G)

11. SAVING AND INVESTMENT
• Private Saving is the amount of income that
households have left after paying their taxes
and paying for their consumption.
• Public Saving is the amount of tax revenue
that the government has left after paying for
its spending.
• For the economy as a whole, saving must be
equal to investment.

12. SAVING AND INVESTMENT
• Savers and borrowers are matched up with
one another through markets governed by
supply and demand of the loanable funds.
• Economists work with a simplified model in
which they assume there is just one market
that brings the ones who want to lend money
(savers) together with the ones who want to
borrow (firms with investment projects).

13. THE EQUILIBRIUM INTEREST RATE
• This hypothetical market is known as the
loanable funds market.
• The price that is determined in this market is
the interest rate (r).
• The interest rate is the return a lender
receives for allowing borrowers the use of a
dollar for one year, calculated as a percentage
of the amount borrowed.

14. THE EQUILIBRIUM INTEREST RATE
• The interest rate can be measured in real or
nominal terms (with or without the expected
inflation included).
• However, in real life neither the borrowers nor
the lenders know what the future inflation rate
will be when they make a deal, so the loan
contracts specify a nominal interest rate, and the
model is drawn with the vertical axis measuring
the nominal interest rate for a given expected
future inflation rate.

15. THE EQUILIBRIUM INTEREST RATE
• The interest rate can be measured in real or
nominal terms (with or without the expected
inflation included).
• However, in real life neither the borrowers nor
the lenders know what the future inflation rate
will be when they make a deal, so the loan
contracts specify a nominal interest rate, and the
model is drawn with the vertical axis measuring
the nominal interest rate for a given expected
future inflation rate.

16. THE EQUILIBRIUM INTEREST RATE
• As long as the expected inflation rate does not
change, changes in nominal interest rate also
lead to changes in the real interest rate.

17. MODEL FOR
THE LOANABLE FUNDS MARKET
• On the model for the loanable funds
market, the horizontal axis shows the quantity
of loanable funds, and the vertical axis shows
the interest rate (the price of borrowing).

18. THE MARKET FOR LOANABLE FUNDS
Interest
Rate
Loanable Funds

19. DEMAND FOR LOANABLE FUNDS
• The demand curve for loanable funds slopes
downward, because the decision for a
business to borrow money to finance a project
depends on the interest rate the business
faces and the rate of return on its project
(which is the profit earned on the
project, expressed as a percentage of its cost):

20. DEMAND FOR LOANABLE FUNDS

21. DEMAND FOR LOANABLE FUNDS
Interest
Rate
Demand
Loanable Funds

22. SUPPLY OF LOANABLE FUNDS
• The interest rate is also an important factor
for analyzing the supply of loanable funds.
• Savers incur an opportunity cost when they
lend to a business (the alternate use of these
funds).
• Whether an individual decides to become a
lender or not depends on the interest rate
received in return.

23. SUPPLY OF LOANABLE FUNDS
• More people are willing to forgo current
consumption and make a loan when the
interest rate is higher.
• Therefore, the hypothetical supply curve of
loanable funds slopes upward.

24. SUPPLY OF LOANABLE FUNDS
Interest
Rate
Loanable Funds

25. THE EQUILIBRIUM INTEREST RATE
• The equilibrium interest rate is the interest
rate at which the quantity of loanable funds
supplied equals the quantity of loanable funds
demanded.
• The market for loanable funds matches up
desired savings with desired investment
spending; in equilibrium, the quantity of
funds that savers want to lend is equal to the
quantity of funds that firms want to borrow.

26. EQUILIBRIUM IN THE LOANABLE FUNDS MARKET
Interest
Rate
Supply
Movement to
equilibrium is
5% consistent with
principles of supply
and demand.
Demand
$1,200 Loanable Funds

27. EQUILIBRIUM IN
THE LOANABLE FUNDS MARKET
• The match-up of savers and borrowers is efficient
for two reasons:
1. The right investments get made (the investment
projects that are actually financed have higher
rates of return than that of the ones that do not
get financed).
2. The right people do the saving (the potential
savers who actually lend funds are willing to
lend for lower interest rates than those who do
not).

28. CHANGES IN THE
EQUILIBRIUM INTEREST RATE
• The equilibrium interest rate changes when
there is a shift of the demand curve for
loanable funds, the supply curve for loanable
funds, or both.

29. SHIFTS OF THE DEMAND
FOR LOANABLE FUNDS
• Factors that cause the demand curve for loanable
funds to shift:
1. Changes in perceived business opportunities
2. Changes in government spending
An increase in the demand for loanable funds
causes the demand curve for loanable funds to shift
to the right, increasing the quantity demanded of
loanable funds to increase at any given interest
rate, and the equilibrium interest rate rises.

30. THE MARKET FOR LOANABLE FUNDS
Interest
Rate
Supply
6%
5%
Demand
$1,200 $1,300 Loanable Funds

31. THE CROWDING-OUT EFFECT
• An increase in the government’s deficit shifts
to demand curve for loanable funds to the
right, which leads to a higher interest rate.
• If the interest rate rises, businesses will cut
back on their investment spending.
• So, a rise in the government budget deficit
tends to reduce overall investment spending.
• This negative effect of government budget
deficits on investment spending is called
crowding out.

32. SHIFTS OF THE SUPPLY OF LOANABLE
FUNDS
• The factors that can cause the supply of
loanable funds to shift are:
1. Changes in private savings behavior
2. Changes in capital inflows
An increase in the supply of loanable funds
means that the quantity of funds supplied rises
at any given interest rate, so the supply curve
shifts to the right, and the equilibrium interest
rate falls.

33. The Market For Loanable Funds
Interest
Rate
Supply
5%
4%
Demand
$1,200 $1,300 Loanable Funds

34. INFLATION AND INTEREST RATES
• The most important factor affecting interest
rates over time is changing expectations about
future inflation, which shift both the supply
and the demand for loanable funds.
• The distinction between nominal interest rate
and the real interest rate:
Real interest rate=Nominal interest rate – Inflation rate
• The true cost of borrowing is the real interest rate,
not the nominal interest rate.

35. INFLATION AND INTEREST RATES
• The expectations of borrowers and lenders
about future inflation rates are normally
based on recent experience.
• According to the Fisher effect, an increase in
the expected future inflation drives up the
nominal interest rate, leaving the expected
real interest rate unchanged.

36. INFLATION AND INTEREST RATES
• Both lenders and borrowers base their
decisions on the expected real interest rate.
As long as inflation is expected, it does not
affect the equilibrium quantity of loanable
funds or the expected real interest rate; all it
affects is the equilibrium nominal interest
rate.

37. RECONCILING
THE TWO INTEREST RATE MODELS
• Using the liquidity preference model, a fall in
the interest rate leads to a rise in investment
spending (I), which then leads to a rise in both
real GDP and consumer spending (C).
• It also leads to a rise in savings, since at each
step of the multiplier process, part of the
increase in DI is saved.

38. RECONCILING
THE TWO INTEREST RATE MODELS
• According to the savings-investment spending
identity, total savings in the economy is
always equal to investment spending.
• When a fall in the interest rate leads to higher
investment spending, the resulting increase in
real GDP generates exactly enough additional
savings to match the rise in investment
spending.

39. RECONCILING THE TWO INTEREST RATE
MODELS: THE LIQUIDITY PREFERENCE MODEL
• According to the liquidity preference model,
the equilibrium interest rate in the economy is
the rate at which the quantity of money
supplied is equal to the quantity of money
demanded in the money market.

40. RECONCILING THE TWO INTEREST RATE
MODELS: THE LOANABLE FUNDS MODEL
• According to the loanable funds model, the
equilibrium interest rate in the economy is the
rate at which the quantity of loanable funds
supplied is equal to the quantity of loanable
funds demanded in the market for loanable
funds.

41. RECONCILING THE TWO INTEREST RATE
MODELS
• Both the money market and the market for
loanable funds are initially in equilibrium with the
same interest rate.
• This fact will always be true. If the Fed increases
the money supply:
1. In the liquidity preference model, this pushes the
money supply curve rightward, causing the
equilibrium interest rate in to market to fall, moving
to a new short-run equilibrium interest rate.

42. RECONCILING THE TWO INTEREST RATE
MODELS
2. In the loanable funds market model, in the
short run, the fall in the interest rate due to
the increase in the money supply leads to a
rise in real GDP, which leads to a rise in
savings through the multiplier process. This
rise in savings shifts the supply curve for
loanable funds rightward, and reducing the
equilibrium interest rate in the loanable
funds market.

43. RECONCILING THE TWO INTEREST RATE
MODELS
• Since savings rise by exactly enough to match
the rise in investment spending, so this tells us
that the equilibrium rate in the loanable funds
market falls to exactly the same as the new
equilibrium interest rate in the money market.

44. EQUILIBRIUM INTEREST RATE IS THE SAME IN
BOTH MODELS
• In the short run, the supply and demand for
money determine the interest rate, and the
loanable funds market follows the lead of the
money market.
• When a change in the supply of money leads
to a change in the interest rate, the resulting
change in real GDP causes the supply of
loanable funds to change as well.

45. THE INTEREST RATE IN THE LONG RUN
• In the short run, an increase in the money
supply leads to a fall in the interest rate, and a
decrease in the money supply leads to a rise in
the interest rate.
• In the long run, however, changes in the
money supply don’t affect the interest rate.

46. THE INTEREST RATE IN THE LONG RUN
• If the money supply rises, this initially reduces
the interest rate.
• However, in the long run, the aggregate price
level will rise by the same proportion as the
increase in money supply.
• A rise in the aggregate price level increases
money demand in the same proportion.
• So in the long run, the money demand curve
shifts rightward, and the equilibrium interest rate
rises back to its original level.

47. THE INTEREST RATE IN THE LONG RUN
• In the loanable funds market, an increase in the
money supply leads to a short-run rise in real
GDP, and shifts the supply of loanable funds
rightward.
• In the long run, real GDP falls back to its original
level as wages and other nominal prices rise.
• As a result, the supply of loanable funds, which
initially shifted rightward, shifts back to its
original level.

48. THE INTEREST RATE IN THE LONG RUN
• In the long run, changes in the money supply
do not affect the interest rate.
• What determines the interest rate in the long
run is the supply and demand for loanable
funds.
• In the long run the equilibrium interest rate is
the rate that matches the supply of loanable
funds with the demand for loanable funds
when the real GDP equals potential output.

49. CONCLUSIONS
• Financial markets coordinate borrowing and
lending and thereby help allocate the
economy’s scarce resources efficiently.
• Financial markets are like other markets in the
economy. The price in the loanable funds
market - interest rate - is governed by the
forces of supply and demand.