Government & changes in the loanable funds market

Changes in the Demand for Loanable Funds

If firms see an increase in their expected profits, they are more likely to increase their investment and increase their demand for loanable funds to finance that investment.

In this case, the demand for loanable funds curve shifts to the right.



We see that the result gives an increase in real interest rate, and an increase in loanable funds.

Changes in the Supply for Loanable Funds

There are four factors that can shift the loanable funds supply curve:

1. Disposable income: this is the households’ income earned subtracted by net taxes. If disposable income increases and everything holds the same, then consumption expenditure increases, but less than the increase in income. In other words, the increased income causes more savings.
2. Expected Future Income: If a household expects higher income in the future, then they tend to spend more and save less today.
3. Wealth: The higher a household’s wealth, the smaller their savings are. If their increase of wealth is due to capital gain, then a household see’s less reason to save.
4. Default Risk: is the risk that a loan will not be paid back. The greater the risk, the higher the interest rate needs to be so that the lender feels that it is worth lending.

If any of the four changes in the factor happens, then the supply for loanable funds curve shifts to the right.

1. Increase in disposable income
2. Decrease in expected future income
3. Decrease in wealth
4. Decrease in default risk

We see that real interest rate $\, \downarrow \,$ and quantity of loanable funds $\, \uparrow \,$.

Government Budget Surplus

The government can enter the loanable funds market when there is a budget surplus. In this case, the supply of loanable funds shifts to the right.



We see in the graph that savings $\, \downarrow \,$, but investment $\, \uparrow \,$.

Government Budget Deficit

The government can also enter the loanable funds market when there is a budget deficit. In this case, the demand of loanable funds shifts to the right.



We see in the graph that savings $\, \uparrow \,$, but investment $\, \downarrow \,$.

Crowding-Out Effect: is when a government budget deficit raises real interest, which decreases (crowds out) investments. The high interest rates encourage saving, which helps finance the government deficit.

The Ricardo-Barro Effect: is the idea that a government surplus or deficit does not affect interest rates.



Why?

1. Government budget deficit increases demand for loanable funds
2. Rational taxpayers see that future taxes are higher.
3. They save more, thus the supply for loanable funds shift to the right

Result: No changes to investment, and an increase to the quantity of loanable funds.