The Loanable Funds theory We use the term “loanable funds market” to describe the arrangements and institutions by which saving of households is made available to borrowers.

Factor income Consumption 1.Leakages must be recycled if total spending is to match full-employment GDP. 2.According to the Classical theory, the loanable funds market acts as a conduit to transfer spending power (S) from households to borrowing units (firms and government units). 3.Saving (S) is the “source” of loanable funds. Saving Net taxes

1.To have a more secure future, to start a business, to finance a child’s education, to satisfy miserliness,... 2.To earn interest. We view interest as the “reward for saving” or the “reward for postponing gratification.”

Value of $1,000 in 3 years at alternative interest rates The opportunity cost of spending now (measured in lost future spending) is positively related to the interest rate.

Saving = Supply of Funds Trillions of Dollars 0 Interest rate 3% 5% Supply of Funds

To finance the acquisition of long-lived capital goods. The rate of interest is the cost of borrowing or the price of loanable funds. The investment demand curve indicates the level of investment spending at various interest rates. As the interest rate decreases, more investment projects become attractive in the assessment of business decision- makers—hence, the investment demand function is downward-sloping with respect to the interest rate.

Investment Demand Trillions of Dollars 0 Interest rate 3% 5% 1.5 Demand for Funds by Business 1.0 A B When the interest rate falls, investment spending and the business borrowing needed to finance it rises.

Public sector borrowing Let G denote public sector (or government) spending for goods and services in a year T is net tax receipts in a year. If G is greater than T, the the public sector has a budget deficit equal to G – T. If T is greater than G, then the public sector has a surplus equal to T – G. If the public sector has a budget deficit, it must borrow.

Federal Government Budget Surplus (Deficit) in billions,

Public Sector Borrowing in Classical G = $2 trillion T = $1.25 trillion Therefore, Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion % 3% Government Demand for Funds Interest Rate Trillions of Dollars A B

Demand for Loanable Funds (in Trillions)

Interest Rate Trillions of Dollars0 3% 5% Total Demand for Funds

Interest Rate Trillions of Dollars Loanable Funds Market Equilibrium Total Supply of Funds (Saving) Total Demand for Funds (Investment + Deficit) E5%

Changes in government spending, transfer payments, and taxes designed to change total spending in the economy and thereby influence total output and employment.

Crowding out is the idea that an increase in one component of spending will cause a decrease in other spending components. An increase in G may cause a decrease in C, I P, or both—that is, government spending may “crowd out” private spending.

Interest Rate Trillions of Dollars Crowding Out With an Initial Budget Deficit Total Supply of Funds (Saving) D 1 = I P + G 1 - T H 5% D 2 = I P + G 2 - T 7% A C B Increase in G = AH Decrease in C = AC Decrease in I P = CH

Interest Rate Trillions of Dollars Effects of a Reduction in the Government Surplus S 1 = Savings + T – G 1 D = Investment B 5% S 2 = Savings + T – G 2 A H 7% C