Copyright © 2004 South-Western The Loanable Funds Market Mod 29

Copyright © 2004 South-Western Two Models of the Interest Rate Liquidity Preference Model Loanable Funds Market

Copyright © 2004 South-Western THE MARKET FOR LOANABLE FUNDS The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Loanable fundsLoanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. market for loanable funds.Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

Copyright © 2004 South-Western Supply and Demand for Loanable Funds The SUPPLY of loanable funds comes from people who have extra income they want to save and lend out. The DEMAND for loanable funds comes from households and firms that wish to borrow to make investments.

Copyright © 2004 South-Western Supply and Demand for Loanable Funds The interest rate is the “PRICE” of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate

The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Real Interest Rate RIR Supply Demand % Q Copyright©2004 South-Western QLF

Copyright © 2004 South-Western Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment 1.Taxes and saving 2.Taxes and investment 3.Government budget deficits

Copyright © 2004 South-Western Policy 1: Saving DISincentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Copyright © 2004 South-Western Policy 1: Saving Incentives A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases. If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600 Copyright©2004 South-Western

Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

An Increase in the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400 Copyright©2004 South-Western

Policy 3: Government Budget Deficits A budget deficit increases the demand for loanable funds. Shifts the demand curve to the right. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds. The deficit borrowing crowds out private borrowers who are trying to finance investments.

Copyright © 2004 South-Western The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 1.Government borrowing increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400 Copyright©2004 South-Western

Policy 4: Government Budget Surpluses A budget surplus increases the supply of loanable funds: Shifts the supply curve to the right Decreases the equilibrium interest rate. Increases the equilibrium quantity of loanable funds. When government increases national saving by running a surplus, the interest rate falls and investment rises.

The Effect of a Government Budget Surplus Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand 1. A budget surplus iincreaser the supply of loanable funds... 5% $1,200 4% $1,600 Copyright©2004 South-Western

A Summary of Shifts of Supply or Demand for Loanable Funds Shifts of Supply: Changes in Savings Behavior Changes in Capital Inflows Shifts of Demand Changes in Business Opportunities for investment Changes in Government Borrowing

Copyright © 2004 South-Western The Loanable Funds Graph Worksheet Practice