Loanable Funds Market
• Chapter 24
TIPS Bond
• The US Treasury offers bonds whose principal
and coupon payments increase with the
inflation rate.
• Investors are paid off in terms of real
purchasing power.
• Yield is equivalent to a real interest rate.
Additional Information from U.S. Treasury
Falling Yields
10-Year Treasury Inflation-Indexed Security, Constant
Maturity (DFII10), Percent, Annual, Not Seasonally Adjusted
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
-0.5
-1
Loanable Funds Market
• Consider the financial market at its broadest and
most abstract.
• an amalgamation of the bond market and the lending
market (banks, etc.)
• Map the relationship between the real interest rate
and the quantity of funds that are lent.
• Supply curve represents the behavior of savers & lenders
• Demand curve represents the behavior of borrowers
Demand Curve: Loanable Funds
• Why does the demand curve slope down?
• Firms borrow to finance investment projects. If
the return on investment falls below the interest
rate, the project is not worthwhile. The higher
the interest rate, the fewer projects are above the
hurdle.
• Households borrow to finance housing. The
higher are interest rates, the smaller is the house
that the householders can buy with a mortgage
payment that they can afford.
Supply Curve: Loanable Funds
• Why does the supply curve slope up?
Substitution Effect: When real interest rates
offered by banks are high, savers are rewarded
with more future consumption and are likely to be
induced to save more.
Closed economy equilibrium
• In closed economy, market forces should cause
supply and demand for loanable funds to
equilibrate at a real interest rate where supply
equals demand.
• Shifts in demand or supply change equilibrium
real rate as in standard supply-demand model.
Competitive Market Equilibrium:
Loanable Funds Market
r
DLF
SLF
LF
Competitive Market Equilibrium:
Loanable Funds Market
r
DLF
SLF
r*
LF
LF*
Demand for Loanable Funds: Determinants
Private
Real interest rate –
Restrictions (LtV,
Collateral Constraints)
Corporate
3. Profitability of business
projects +
4. Uncertainty of business
investment –
5. Retained earnings –
Mortgage Market
6. Demand for Housing +
1.
2.
Public
1. Government Deficits +
2. Corporate Profits Tax –
Supply of Loanable Funds: Determinants
Private
Public
1. Real interest rate +
5. Government Surplus +
Household
6. Interest Income Tax –
2. Disposable Income +
3. Expected Future Income –
4. Value of Assets/Wealth –
5. Default Risk –
6. Uncertainty of Future
Income +
Ex. Uncertainty about Future Capital Infrastructure
Investment
r
DLF'
1
r*
r**
SLF
DLF
2
LF
LF**
LF*
Consumers become more worried about the
future.
r
DLF
SLF
SLF'
r*
1
2
r**
LF
LF*
LF**
Government Surplus
• Government surplus is gap between govt revenue and outlays
and can be positive or negative.
• If net positive, it adds to the supply of loanable funds.
• If net negative, it adds to the demand for loanable funds.
IMF Fiscal Monitor
Example: Swiss Government strikes a deal
to raise taxes and cut spending
r
DLF
SLFP
SLF
1
r*
2
r**
LF*
LF**
LF
Example Japan Government runs a deficit to
finance infrastructure reinforcement.
Budget Plan
r
DLFP
SLF
DLF
2
r**
1
r*
LF*
LF**
LF
Globalization and the Loanable Funds Market
• OUaT, we might have thought of the loanable
funds market as being national in nature –
especially for large economies. These days it
appears that even the USA is part of a single
global market. [China possible exception]
• Otherwise take global interest rate as given.
Perspectives on Financial Globalization
SOURCE: PRELIMINARY REPORT: 27 JULY 2011, BIS REPORTING BANKS
HTTP://WWW.BIS.ORG/STATISTICS/BANKSTATS.HTM
Dec.2010
Dec.2009
Dec.2008
Dec.2007
Dec.2006
Dec.2005
Dec.2004
Dec.2003
Dec.2002
Dec.2001
Dec.2000
Dec.1999
Dec.1998
Dec.1997
Dec.1996
Dec.1995
Dec.1994
Dec.1993
Dec.1992
Dec.1991
Dec.1990
Dec.1989
Dec.1988
Dec.1987
Dec.1986
Dec.1985
Dec.1984
Dec.1983
Dec.1982
Dec.1981
Dec.1980
Dec.1979
Dec.1978
Dec.1977
Total Assets
Summary of International
Positions,
Amount Outstanding
(In billions of US dollars)
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
Mar.1987
Sep.1987
Mar.1988
Sep.1988
Mar.1989
Sep.1989
Mar.1990
Sep.1990
Mar.1991
Sep.1991
Mar.1992
Sep.1992
Mar.1993
Sep.1993
Mar.1994
Sep.1994
Mar.1995
Sep.1995
Mar.1996
Sep.1996
Mar.1997
Sep.1997
Mar.1998
Sep.1998
Mar.1999
Sep.1999
Mar.2000
Sep.2000
Mar.2001
Sep.2001
Mar.2002
Sep.2002
Mar.2003
Sep.2003
Mar.2004
Sep.2004
Mar.2005
Sep.2005
Mar.2006
Sep.2006
Mar.2007
Sep.2007
Mar.2008
Sep.2008
Mar.2009
Sep.2009
Mar.2010
Sep.2010
Mar.2011
International debt securities - all issuers
(in billions of US dollars)
35000
30000
25000
20000
15000
10000
5000
0
SOURCE: BIS QUARTERLY REVIEW: 'JUNE 2011
TABLE 12A: INTERNATIONAL DEBT SECURITIES -ALL ISSUERS
HTTP://WWW.BIS.ORG/STATISTICS/SECSTATS.HTM
Competitive Market Equilibrium:
World Loanable Funds Market
r
SLFW
DLFW
rW
LFW
LF
National Loanable Funds Markets in a Global
World
•
How do national economies relate to the
global financial market?
Countries will face an external interest rate, rW,
unaffected by national savings or investment.
2. International lending (borrowing) will make up
the gap between savings and investment.
1.
Competitive Market Equilibrium:
Demand exceeds Supply
r
SLF
DLF
rW
International
Borrowing
LF
Investment Boom Mongolia
[r Doesn’t Rise, Gap made up by Capital Inflows]
r
DLF
DLF'
SLF
Boomtown
Mongolia
Financial Times
1
rW
2
Borrowing
LF
LF*
LF**
Competitive Market Equilibrium:
Supply exceeds Demand
r
SLF
DLF
International
Lending
rW
LF
Bloomberg Norway Wealth Fund
40% Bonds
Oil Fields Running at peak, Norway
(r does not fall, gap made up by capital outflows)
r
SLF'
SLF
DLF
Lending
rW
2
1
LF
Global LF Market
• Only very large changes in large countries or international
trends will have an impact on real interest rates.
Savings Glut
• Theory put forth by Fed Chairman explaining the U.S.
trade deficit: Washington Post Article
IMF Data Mapper
Growing Gap between savings & investment
in Asia
IMF Regional Outlook Asia Pacific 2010
The Classic Demographic Transition
Model
Link
Stage 1
Stage 2
Stage 3
Stage 4
Birth rate
Natural
increase
Death rate
Time
Note: Natural increase is produced from the excess of births over deaths.
Link Population by age, sex and urban/rural residence
Aging Population Structure
Age Distribution Japan
12000000
10000000
People
8000000
6000000
2010
1990
1970
4000000
2000000
0
Population Structure and Employment
Japan: Employment to Population Ratio
54.00%
53.00%
52.00%
51.00%
50.00%
49.00%
48.00%
47.00%
46.00%
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Japan Trade Balance
5.00%
4.00%
3.00%
2.00%
1.00%
-1.00%
-2.00%
-3.00%
NX/GDP %
0.00%
Savings Glut
r
SLFW
DLFW'
DLFW
SLFW '
rW
rWW
LFW
LF
World Interest Rate Falls
(Passive Response Economy)
r
DLF
SLF
1
rW
rWW
2
2
International
Borrowing
LF
US Current Account
1.00%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
NX
NFI
CA
China Loanable Funds Market
• High savings rates even relative to high investment,
•
•
•
•
•
limited alternative equity assets, real estate very
expensive.
Capital Controls prevent purchase of foreign reserves
Gov’t setting of deposit and lending rates (even long term)
Limited number of firms deemed eligible for credit
State Owned Banks have Excess Funds
SAFE absorbs these funds and buys foreign reserves.
Loanable Funds Market China
r
SLF
DLF
International
Lending
rREG
LF
NOMINAL YIELDS
Optional
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so they
must be made on the basis of an ex ante
(predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest rate is
determined by forces in the financial market.
Money interest rate is just the real ex ante rate
plus the market’s consensus forecast of
inflation.
it  rt EA   tFORECAST
1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Great Inflation Download
Fisher Effect:
OECD Economies Great Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Loanable Funds Market
Fisher Effect
NDLF
NSLF
SLF
DLF
i*
r*

 tE1
E
t 1
LF*
LF
Learning Outcome
• Use the Loanable Funds model to analyze the
effects of events on savings, investment, and real
interest rates in capital markets.
• Model Global Loanable Funds market and the
determinants of current accounts.
• Use expected inflation and the Fisher effect to
determine nominal interest rates.