LOANABLE FUNDS MARKETLOANABLE FUNDS MARKET

SUPPLY and DEMAND for LOANABLE FUNDS

Saving is the source of the supply of loanable funds.

-For example, when a household makes a deposit in a bank.

Investment is the source of the demand of loanable funds.

-For example, when households take out mortgages to buy homes. Or, when firms borrow to buy new capital equipment.

The interest rate is the price of a loan. A high interest rate makes borrowing

more expensive, thus the quantity of loans demanded falls.

Similarly, a high rate makes savings more attractive, and thus increases the amount of loanable funds supplied.

If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity demanded.

The result is a shortage of funds, which would encourage lenders to raise the interest rate, and thereby increase saving and dissuade borrowing for investment.

Conversely, if interest rates were higher than equilibrium, then the quantity of loans supplied would exceed those demanded.

As lenders competed for scarce borrowers, interest rates would be driven down to reach equilibrium.

Remember, economists distinguish between nominal and real interest rates.

The real interest rate is the nominal rate adjusted for inflation.

Nominal rate = Real interest rate + Inflation Premium.

Real interest rates more accurately reflect the real return. Therefore, the supply and demand for loanable funds depend on the real interest rate.

Saving Incentives Policy

American families save a smaller fraction of their incomes as compared to other industrialized countries, like Japan and Germany. (Note: As of 2009, this has changed somewhat due to the current recession. National Savings has increased.)

However, the low savings rate might be due to tax policies in the U.S. Tax on interest income reduces incentives to save.

What if tax incentives were created for people to shelter some of their savings income? How would this impact the market for loanable funds?

First, which curve would this policy affect?

Because the tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate.

Therefore, the supply of funds would shift to the right.

As a result, interest rates would be lower, and investment would increase.

Investment Incentives Policy

Suppose Congress decides to pass an investment tax credit to encourage firms to build new factories.

As this is investment policy, it would affect demand. It would change the demand for loanable funds as firms are rewarded for borrowing and investing in new capital.

Next, since firms would have an incentive to increase investment at any interest rate, the demand curve would shift to the right.

Interest rates would then rise and the quantity of loanable funds would increase. In addition, saving would increase as well.

Government Budget Deficits and Surpluses

Policies A budget deficit is an excess of government spending over tax revenue.

Governments finance deficits by borrowing in the bond market (the accumulation of past borrowing is our national debt).

A budget surplus can be used to pay down some of the debt.

When spending equals revenue, we have a balanced budget.

What would happen if we ran a budget deficit? A change in the government budget balance

represents a change in public saving, and, therefore, in the supply of loanable funds.

When the government runs a deficit, then we have negative public savings. Thus, the supply curve would shift to the left as the supply of the funds would be reduced.

This would result in an increased interest rate and investment would fall.

Crowding Out

This fall in investment due to the government borrowing is known as a phenomenon called “crowding out”.

Government borrowing crowds out private investment.

This is one of the risks of expansionary fiscal policy. Here’s what the CBO said about the stimulus plan in

February: http://www.washingtontimes.com/news/2009/feb/04/

cbo-obama-stimulus-harmful-over-long-haul/