Financial Sector:
Loanable Funds Market
AP Economics
Mr. Bordelon
Loanable Funds Market
• Economists work with a simplified model in
which they assume that there is just one market
that brings together those who want to lend
money (savers) and those who want to borrow
(firms with investment spending projects).
• This hypothetical market is known as the
loanable funds market.
• The price that is determined in the loanable
funds market is the interest rate, denoted by r.
Loanable Funds Market
• Savers and borrowers care about the real
interest rate because that is what they earn or
pay after inflation.
▫ Real interest rate = nominal interest rate – expected inflation
• If expected inflation =0%, then real interest rate
= nominal interest rate.
▫ If expected inflation is constant, any change in the
nominal rate will be reflected in an identical
change in the real rate.
Demand for Loanable Funds
Comes from Borrowers
Demand is downward sloping. Firms
borrow to pay for capital investment
projects. If the project has an expected rate
of return that exceeds the real interest rate,
the investment will be
profitable, and the funds will be demanded.
Rate of return (%) = (Revenue from
project – Cost of project)/(Cost of
project) x 100%
As the real interest rate decreases, more
projects become profitable, so the quantity
of funds demanded will increase.
Similarly, if the project’s expected rate of
return is below the real interest rate,
investment will not be profitable and funds
will not be demanded.
As the real interest rate increases, more
projects become unprofitable, so the
quantity of funds demanded will decrease.
Supply of Loanable Funds
Comes from Savers
Supply is upward sloping. Savers can lend
their money to borrowers, but in doing so
must forgo consumption.
In order to compensate for the forgone
consumption, savers must receive interest
income and as the real
interest rate rises, the opportunity to earn
more income rises, so more dollars will be
saved.
As the real interest rate rises, the quantity
of funds supplied will increase.
Similarly, it may be costly in opportunity
cost for savers to lend money, so they’ll
keep it as cash on hand.
If the interest rate is too low, then the
quantity supplied of loanable funds will
decrease.
As the real interest rate decreases, the
quantity of funds supplied will decrease.
Loanable Funds Market
Equilibrium
Equilibrium interest rate here is rE at which QE
dollars are lent and borrowed.
Investment spending projects with a rate of
return of rE% or more are funded.
Projects with a rate of return of less than rE%
are not funded.
Only lenders willing to accept an interest rate
of rE% or less will have their offers to lend
funds accepted.
At rE%, quantity of loanable funds supplied
equals quantity of loanable funds demanded.
rE% in this graph is 8%, with $300 billion in
funds lent and borrowed.
Investment spending projects with a rate of
return of 8% or higher receive funding.
Those with a lower rate of return do not.
Lenders who demand an interest rate of 8% or
lower have their offers of loans accepted.
Those who demand a higher interest rate do
not.
Loanable Funds Market
Equilibrium
Looking at this graph, at rE, quantity of
loanable funds supplied equals quantity
of loanable funds demanded. rE in this
graph is 8%, with $300 billion in funds
lent and borrowed.
Investment spending projects with a
rate of return of 8% or higher receive
funding.
Those with a lower rate of return do not.
Lenders who demand an interest rate of
8% or lower have their offers of loans
accepted.
Those who demand a higher interest
rate do not.
Shifts of Demand for
Loanable Funds
Change in perceived business
opportunities. A change in beliefs
about the rate of return on investment
spending can increase or reduce the
amount of desired spending at any given
interest rate.
If firms believe that the economy is
booming, demand for loanable
funds will increase.
If firms believe the economy is tanking,
demand for loanable funds will
decrease.
Shifts of Demand for
Loanable Funds
Changes in government
borrowing. Governments that run
budget deficits are major sources of the
demand for loanable funds.
If government runs a budget deficit, the
Treasury must borrow funds and
acquire more debt. This increases
demand for loanable funds.
If government runs a budget surplus,
less debt would be required and the
demand for loanable funds decreases.
Crowding out. When a government
deficit drives up interest rate and leads
to reduced investment spending.
At higher interest rates, some
investment will be “crowded out” by
government demand for loanable funds.
Shifts of Supply of Loanable
Funds
Changes in private savings
behavior. If households decide to
consume more and save less, the supply
of loanable funds will shift to the left.
If households decide to consume less
and save more, the supply of loanable
funds will shift to the right.
Changes in capital inflows. If a
nation is perceived to have a stable
government, a strong economy and is a
good place to save money, foreign
money will flow into that nation’s
financial markets, increasing the supply
of loanable funds.
If a nation is considered unstable, and is
a bad place to save money, foreign
money will flow out of the nation’s
financial markets, decreasing the supply
of loanable funds.
Inflation and Interest Rates
• Anything that shifts either the supply of loanable funds
curve or the demand for loanable funds curve changes
the interest rate.
• Dealing with unexpected inflation impacts borrowers
and lenders. Economists apply the effect of inflation on
borrowers and lenders by distinguishing between the
nominal interest rate and the real interest rate:
▫ Real interest rate = Nominal interest rate — Inflation rate
 For borrowers, the true cost of borrowing is the real interest
rate, not the nominal interest rate.
 For lenders, the true payoff to lending is the real interest rate,
not the nominal interest rate.
Fisher Effect
Fisher Effect. An
increase in expected future
inflation drives up the
nominal interest rate, leaving
the expected real interest
rate unchanged. Each
additional percentage point
of expected future inflation
drives up the nominal
interest by that additional
percentage point.
Both lenders and borrowers
base their decisions on the
expected real interest rate.
As long as the level of
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.
Fisher Effect
Assume an expected
inflation rate of 0%. This
makes the equilibrium
nominal interest rate as
4%. Increasing expected
future inflation pushes
both D and S upwards by 1
percentage point fore very
increase in expected future
inflation.
Here, D10 and S10 are the
curves for when expected
inflation is 10%. The 10%
expected inflation raises
equilibrium nominal
interest rate to 14%.
Expected real interest
remains at 4%. QE
remains unchanged.
Liquidity Preference and Loanable
Funds Models Together—Short Run
Liquidity Preference and Loanable
Funds Models Together—Short Run
1.
2.
3.
4.
5.
On the liquidity preference model, a decrease in interest rates lead to an increase in investment spending, I, which then leads to an
increase in both real GDP and consumer spending, C.
The increase in real GDP leads to an increase in consumer spending and also leads to an increase in savings. At each stage of the
multiplier process, part of the increase in disposable income is saved.
According to the savings–investment spending identity, total savings in the economy is always equal to investment spending.
A decrease in the interest rate leads to higher investment spending, and the resulting increase in real GDP generates exactly enough
additional savings to match the increase in investment spending.
After a decrease in the interest rate, the quantity of savings supplied increases exactly enough to match the quantity of savings
demanded.
This analysis can be done in reverse when you see an increase in interest rates.
Liquidity Preference and Loanable
Funds Models Together—Long Run
Liquidity Preference and Loanable
Funds Models Together—Long Run
1.
2.
3.
4.
5.
MS increases from M1 to M2. This reduces the interest rate to r2.
In the long run , APL increases by same proportion as the increase in MS.
An increase in APL increases MD in the same proportion. In the long run, MD curve shifts out to MD2,
and the equilibrium interest rate rises back to its original level, r1.
In the loanable funds market, an increase in MS leads to a short-run increase in real GDP and that shifts
supply of loanable funds to the right from S1 to S2.
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, S, which initially shifted from S1 to S2, shifts back to S1.
Liquidity Preference and Loanable
Funds Models Together—the point!
• In the short run, an increase in MS leads to a
decrease in the interest rate, and a decrease in
the MS leads to an increase in the interest rate.
• In the long run, changes in MS don’t affect the
interest rate. Both the money market and
loanable funds markets are in equilibrium.
• In the long run, the equilibrium interest rate
matches the supply and demand for loanable
funds that arise at potential output.
Question 1
• For each of the following scenarios, 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 quantity of loanable funds.
▫ The Chair of the Federal Reserve testifies before Congress
that he/she expects the health of the economy to
significantly improve in coming months.
▫ Households fear an imminent recession and begin to cut
back on discretionary purchases.
▫ The Federal government announces another annual budget
surplus.
▫ The flow of foreign financial capital into American financial
markets begins to decrease.
Question 2
Use the market for loanable funds
shown in the accompanying diagram to
explain what happens to private savings,
private investment spending, and the
rate of interest if the following events
occur. Assume that there are no capital
inflows or outflows.
a. The government reduces the size of
its deficit to zero.
b. At any given interest rate,
consumers decide to save more.
Assume the budget balance is zero.
c. At any given interest rate,
businesses become very optimistic
about the future profitability of
investment spending. Assume the
budget balance is zero.
Question 3
The government is running a budget
balance of zero when it decides to
increase education spending by $200
billion and finance the spending by
selling bonds. The diagram shows the
market for loanable funds before the
government sells the bonds. Assume
that there are no capital inflows or
outflows. How will the equilibrium
interest rate and the equilibrium
quantity of loanable funds change? Is
there any crowding out in the market?
Question 4
• In 2006, Congress estimated that the cost of the Iraq War was
approximately $100 billion a year. Since the U.S. government was
running a budget deficit at the time, assume that the war was
financed by government borrowing, which increases the demand for
loanable funds without affecting supply. This question considers
the likely effect of this government expenditure on the interest rate.
▫ Draw typical demand (D1) and supply (S1) curves for loable funds
without the cost of the war accounted for. Label the vertical axis
“interest rate” and the horizontal axis “quantity of loanable funds.”
Label the equilibrium point (E1) and the equilibrium interest rate (r1).
▫ On the same graph, now include the cost of the war included in the
analysis. Shift the demand curve in the appropriate direction. Label the
new equilibrium point (E2) and the new equilibrium interest rate (r2).
▫ How does the equilibrium rate change in response to government
expenditure on the war? Explain.