. . . 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.

Institutions that allow savers and
borrowers to interact are called financial
intermediaries.
 Types of Financial Intermediaries:
 Banks
- Bond Market
 Stock Market
- Mutual Funds

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.

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.







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
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.

Other financial intermediaries include:
 Savings and Loans Associations
 Credit Unions
 Pension Funds
 Insurance Companies
 Loan Sharks

Recall: GDP is both total income in an
economy and the total expenditure on
the economy’s output of goods and
services:
 Y(GDP) = C + I + G + NX
 Assume a closed economy:
Y=C+I+G
 National Saving or Saving is equal to:
Y-C-G=I=S

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)

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.

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).

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.

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.

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.


As long as the expected inflation rate
does not change, changes in nominal
interest rate also lead to changes in the
real interest rate.

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).
Interest
Rate
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):
Rate of return =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑓𝑟𝑜𝑚 𝑝𝑟𝑜𝑗𝑒𝑐𝑡−𝐶𝑜𝑠𝑡 𝑓𝑟𝑜𝑚 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
X 100
A business will want a loan when the rate of
return on its project is greater than or equal
to the interest rate.
 The lower the interest rate, the larger the
total
quantity
of
loanable
funds
demanded.
 Therefore, the hypothetical demand curve
of loanable funds slopes downward.

Interest
Rate
Demand
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.

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.

Interest
Rate
Loanable Funds
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.

Interest
Rate
Supply
Movement to
equilibrium is
consistent with
principles of supply
and demand.
5%
Demand
$1,200
Loanable Funds
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).


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.
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.

Interest
Rate
Supply
6%
5%
Demand
$1,200
$1,300
Loanable Funds
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.

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.

Interest
Rate
Supply
5%
4%
Demand
$1,200
$1,300
Loanable Funds
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.
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.


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.
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.

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.


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.

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.
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.

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.

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.
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.

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.

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.

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.

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.

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.
