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Notes on Chapter 4

Loanable Funds and the Real Interest Rate

Potential GDP depends on the quantity of productive resources. The

growth rate of PGDP depends on how rapidly the resources grow.

One of the major resources that is important to grow is the economy's

capital stock.

The capital stock includes business capital as well as inventories.

The economy's capital stock is measured by its total physical quantity

and quality of plants, machines, equipments, buildings, inventories of raw

materials and semi-finished goods, highways, schools, etc.

In addition to the privately owned capital stock resulting from private

investment (business investment plus investment in new homes and

additions to inventories), we also have publicly owned capital stock in the

form ofsocial infrastructure capital (highways, dams, schools).

Social infrastructure capital is primarily created by government

investment.

The capital stock is determined by investment decisions.

The funds that finance investment are obtained in the market for loanable

funds.

The market for loanable funds is the market in which households, firms,

governments, banks, and other financial institutions borrow and lend.

To understand the investment and the saving decisions in the loanable

funds market, we have to understand the meaning of the interest rate and

distinguish between nominal interest rate and real interest rate. Classical

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theory treated saving as a direct function of the rate of interest and

investment as an inverse function

INTEREST RATE

Interest rate is the price of fund (loan). It is the rate of interest charged

for the use of money, usually expressed as an annual percentage. The

rate is derived by dividing the amount of interest by the amount of money

borrowed.

Example:

If a bank charged $50 a year to borrow $1,000, the interest rate would be

5%.

The nominal interest rate (i) is the amount of money that a unit of

capital earns.

It is the actual amount paid as interest per unit of currency borrowed for

each period.

When people borrow money from a bank, the bank charges the nominal

interest rate.

When you buy a car from a dealer and pay by installments,the dealer charges you the nominal interest rate.

Investment, saving and consumption all depend on real interest rate (r)

rather than nominal interest rate (i).

The real interest rate (r) is the quantity of goods and services that a unit

of capital earns.

It is nominal interest rate adjusted for inflation.

The real interest rate (r) = nominal interest rate (i) - inflation rate Thus, the nominal interest rate = real interest rate (r) + inflation rate

The real interest rate is the opportunity cost of loanable funds. It is the

opportunity cost of retained earnings.

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Example:

o Suppose a bank has made a one-year loan of 1000 dinars with

nominal interest rate = 5%. At the end of the year, the bank would

receive 1050 (100 * 1.05). That is, the bank gained 5%. Suppose

the inflation rate of that year = 4%. The bank real gain or real

interest rate = 5% - 4% = 1%

Exercise:

If real interest rate is 5 % and inflation rate is 4%. What would be the

nominal interest rate?

Uses and Resources of Loanable Funds

Loanable funds are used in three purposes:

1. Business investment

2. Government budget deficit

3. International investment or lending

Loanable funds come from three resources:

1. Private saving2. Government budget surplus

3. International borrowing

The Demand for Loanable Funds

The quantity of loanable fund demanded is the total quantity of funds

demanded to finance investment, the government budget deficit, and

international investment or lending during a given period. This quantity depends on

1. The real interest rate

2. The expected profit rate

3. Government and international factors

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The demand for loanable funds is the relationship between the quantity

of loanable funds demanded and the real interest rate when all other

influences in borrowing plans remain the same.

Business investment is the main component of loanable funds.

Other things remaining the same, investment decreases if the real

interest rise (r) and increases if the real interest rate (r) fall.

Equivalently, the quantity of real loanable funds demanded decreases if

the real interest rises and increases if the real interest rates fall. Thus, the

quantity of real loanable funds demanded, is negatively related to real

interest rate (r).

From the above discussion, it should be clear that the demand for

loanable funds (DLF) curve is downward sloping, showing the negative

relationship between the real interest rate (r) and the quantity of loanable

funds demanded.

A change in r results in a movement along the DLF curve.

o If r, LF and there is an upward movement along the DLF curve.

o If r, LF and there is a downward movement along the DLFcurve.

Thus a change in the real interest rate brings a change in investment and

a change in the quantity of loanable funds demanded, which is shown by

a movement along loanable funds demand curve.

LF26 36

1

5

DLF0

DLF1

DLF2

r %

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Exercise:

Consider the following table

Year

Nominal

interestrate

Inflationrate

2001 8 42002 7.5 62003 9 7

a. Which year the country was expected to have the highest investment

in?

b. In 2001, the firm thought to invest $10000 in a project and the

expected annual revenue is $300. What is the expected net profit?

Should the firm do the project?

c. In 2003, the firm thought to invest $5000 in a project and the expected

annual revenue is $300. What is the expected net profit? Should the

firm do the project?

Changes in demand for loanable funds (Shifts of DLF curve) A change in any other influence on a firms decision to invest and borrow

funds is shown by a shift of a demand curve.

These other influences are all the factors that affect a firms expected

profit.

When the expected profit changes investment demand changes and

loanable funds change.

Other things remaining the same, the greater the expected profit rate

from the new capital the greater is the amount of investment and the

greater is the demand for loanable funds; and the loanable funds demand

curve shifts rightward to DLF1.

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When the expected profit decreases, investment demand decreases and

the loanable funds demand curve shifts leftward to ID2.

The main factors that affect the expected profit rate are

1. Advances in technology: With the technological advances,

profits are expected to increase in the long run.

2. The phase of the business cycle: During expansion, an increase

in sales brings a higher profit rate; in recession, a decrease in

sales brings a lower profit rate.

3. Taxes: Changes in tax rates influence the firm's after-tax profit

rate.

Changes in the expected profit rate appear to be more important than

changes in the real interest rate in contributing to changes in the

amount of investment in the economy (i.e., shifts in the loanable funds

demand curve are more important than movements along the curve).

The Supply of Loanable Funds The quantity of loanable funds supplied is the total funds available

from private saving, the government budget surplus, and international

borrowing during a given period. This quantity depends on

o The real interest rate

o Disposable income

o Wealth

o Expected future incomeo Government and international factors

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The real interest rate and the quantity loanable funds supplied

(Movements along the Supply of loanable funds curve)

The supply loanable funds (SLF) is the relationship between the

quantity loanable funds supplied and the real interest rate, other things

remaining the same.

Saving is the main item that makes up the supply of loanable funds.

There is a positive relationship between real interest rate and the quantity

of saving, and therefore there is a positive relationship between real

interest rate and quantity loanable funds supplied.

Other things remaining the same, the higher the real interest rate the

greater is the saving; and the lower the real interest rate, the smaller is

the saving.

Equivalently, the higher the real interest rate, the greater is the quantity

loanable funds supplied; and the lower the real interest rate, the smaller

is the quantity loanable funds supplied

The supply of loanable funds curve (SLF) is upward sloping, showing

the positive relationship between the real interest rate and the quantity ofloanable funds supplied.

A change in real interest rate results in a movement along the same SLF

curve, other things remaining the same.

If r S upward movement along SLF curve.

If r S downward movement along SLF curve.

Saving increases when the real interest rate increases because r is the

opportunity cost of consumption.

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Changes in the Supply of Loanable Funds

(Shifts of the SLF curve):

When any influence on saving other

than the real interest rate changes,

saving supply changes and SLF curve shifts.

The three main factors that influence

saving supply are:

Disposable Income: An increase in

households disposable income people

save more at each real interest rate

an increase in SS and a shift of SLF

curve to the right

Wealth: A household wealth equals its assets (what it owns) minus its

debt (what it owes). The purchasing power of households wealth is the

real value of its wealth. It is the quantity of goods and services that the

households wealth can buy.

A decrease in wealth people save more at each real interest rate anincrease in SLF and a shift of SLF curve to the right

Expected future income: A decrease in the expected future income

people save more at each real interest rate an increase in SLF and a

shift of SLF curve to the right

A decrease in disposable income, an increase in wealth, or an increase in

expected future disposable income decreases saving supply and shifts

the SLF curve leftward.

LoanableFunds

r

SLF0

SLF2

SLF1

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EQUILIBRIUM IN FUND MARKET

(DETERMINATION OF THE REAL INTEREST RATE)

As have been seen, other things remaining the

same, the quantities of loanable funds

demanded and supplied depends on the

real interest rate.

The higher the real interest rate, the greater

is the amount of saving and the larger is the

quantity of loanable funds supplied, and

the smaller is the amount of investment

and the smaller is the quantitiy of loanable

funds demanded.

There is one interest rate at which the quantities of loanable funds

demanded and supplied are equal, and that is the equilibrium real interest

rate.

The DLF curve and the SLF curve intersection determine the equilibrium

real interest rate (r*). The financial market is in equilibrium when the real interest rate is such

that the quantity of loanable funds supplied equals the quantity of

loanable funds demanded. There is neither a surplus nor a shortage of

saving so that investors can get the funds they demand and savers can

lend all the funds they have available.

If r> r* the amount of loanable funds supplied > the amount of

loanable funds demanded surplus of funds available (surplus of loans)

lenders will be unable to find borrowers willing to borrow all of the

available funds and r to r* the quantity of loanable fund demanded

r*

r1

r2

Loanabfunds

r

SLF

DLF

I* = S*

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rises and the quantity of loanable funds supplied falls until the two are

brought into equilibrium.

If r< r* the quantity loanable funds supplied < the quantity loanable

funds demanded shortage of the funds available (borrowers can't find

the loans they want, but lenders are able to lend all the funds they have

available) r to r*

Changes in the Real Interest Rate

(Shifts in DLF and SLF)

a. If any of the factors that influencesinvestment change, investment would

change and DLF curve shifts. If firms

expect higher net profit DLF curve

shifts rightward r and the equilibrium

quantity of loanable funds .

b. If any factor that affects saving changes,

saving would change and SLF curve would

shift. If people's disposable income

SLF curve shifts rightward r and the

the equilibrium quantity of loanable funds .

SLF

ID0

* = *

*

LF

rSLF0

DLF0

I* = S*

r*

r1

I1, S1

SLF1

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c. If both I and S both DLF and SLF

curves shifts rightward the amount

of loanable funds but r may , or stay the

same.(it depends on the size of the

shifts of both DLF and SLF).

(Remember the discussion in Ch.3

about the different types of shifts

of both AD and SAS). LF

I1, S1I* = S*

SLF0

SLF1

DLF0

*

DLF1