Loanable funds market

Funds for Financing Investment

Suppose $Y$ is the household’s income. Then,

$Y=C+S+T$

Where:

$C\;$→$\;$ Consumption of goods and services
$S\;$→$\;$ Savings
$T\;$→$\;$ Net tax paid to the government

Recall that income $Y$ is also equal to all the expenditures,

$Y = C + I + G + X -M$

Setting the two equations equal gives us

$C + I + G + X - M = C + S + T$
$I + G + X - M = S + T$
$I + G + X = M + S + T$

Subtracting $G$ and $X$ on both sides will give us investment $I$.

$I = S + (T- G) +(M-X)$

Where investment is financed by:

1. $S\;$→$\;$ Savings
2. $T - G \;$→$\;$ government budget surplus
3. $M - X \;$→$\;$borrowing from the rest of the world

Note: If $T$ > $G$ and $M$ > $X$, then it contributes to financing investments.

The Real & Nominal Interest Rate

Nominal Interest Rate: the amount of dollars that borrowers pay to the lender as interest in a year expressed as a percentage of the value owed to the lender.

Example: If the annual interest paid to the lender is 10$ on a $200 loan, then the nominal interest is:

Nominal Interest Rate = $\frac{10} {200} \, \times 100$ = 5%

Real Interest Rate: is nominal interest that is adjusted to clear the effects of inflation. In other words,

Real Interest $\, \approx \,$ Rate Nominal Interest Rate - Inflation Rate

Example: If the nominal interest rate is 3% and the inflation rate is 1%, then

Real Interest Rate = 3% - 1% = 2%

Real interest rate is important because we are going to see how the demand and supply of loan market determines the real interest rate, and how real interest can affect investments.


Demand & Supply of Loanable Funds

Quantity of Loanable Funds Demanded: the total quantity of funds demanded to finance investment, government budget deficit, and international investment or lending for a provided period.

We will only look at investment.

Demand for Loanable Funds Curve: is the relationship between the quantity of loanable funds demanded and the real interest rate, leaving all other influences the same.

The demand for loanable funds curve looks like the following:



Characteristics of demand for loanable funds curve:

1. Downward sloping
2. As real interest rate $\, \uparrow \,$, then investment $\, \downarrow \,$ and quantity of funds demanded $\, \downarrow \,$
3. As real interest rate $\, \downarrow \,$, then investment $\, \uparrow \,$ and quantity of funds demanded $\, \uparrow \,$

Quantity of Loanable Funds Supplied: the total quantity of funds supplied to finance investment, government budget deficit, and international investment or lending for a provided period.

Supply for Loanable Funds Curve: is the relationship between the quantity of loanable funds supplied and the real interest rate, leaving all other influences the same.

The supply for loanable funds curve looks like the following:



Characteristics of supply for loanable funds curve:

1. Upward sloping
2. As real interest rate $\, \uparrow \,$, then savings $\, \uparrow \,$ and quantity of funds supplied $\, \uparrow \,$
3. As real interest rate $\, \downarrow \,$, then savings $\, \downarrow \,$ and quantity of funds supplied $\, \downarrow \,$

Loanable Funds Market Equilibrium: the intersection of the demand and supply for loanable funds curve is the loanable funds market equilibrium. There is no excess or shortage of loanable funds here.



Depending on the real interest rate, we can have an excess or shortage of loanable funds.

Case 1: If the real interest rate is above the equilibrium interest, then there is a surplus of funds.



Case 2: If the real interest rate is below the equilibrium interest, then there is a shortage of funds.