WHICH ONE IS MORE IMPORTANT TO YOU IF YOU ARE WANTING A LOAN TO BUY A CAR?

WARM UPWhat is the difference between nominal and real interest rates?

MODULE 29:LOANABLE FUNDS MARKET

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Is an interest rate of 50% good or bad?Bad for borrowers but good for lenders

The loanable funds market brings together those

who wish to borrow with those who want to lend

Demand- Inverse relationship between real interest rate and quantity loans

demanded Supply- Direct relationship between real interest rate and quantity loans supplied

This is NOT the same as the money market.

(supply is not vertical)

3

IF EXPECTED INFLATION IS 0%, REAL=NOMINAL

Remember: real interest rate =nominal interest rate-expected inflationIf an investor locks in at 5% and the rate of inflation is 2% then the person is earning real interest rate of 3%.Firms borrow to pay for capital investment projects.If the project has an expected rate of return that exceeds the real interest rate, the investment will be profitable, and the funds will be demanded.

Which do we care about?

Real

Or Nominal?

Demand (comes from borrowers) is downward sloping because the lower the interest rate, the more firms want to borrow.

Supply of loanable funds: comes from savers- is upward sloping.

Formula for loanable funds

RATE OF RETURN % = 100* (Revenue from project- Cost of project)/(Cost of project)

As the real rate falls, more projects become profitable, so the quantity of funds demanded will increase.

LOANABLE FUNDS

Loanable Funds (billions of dollars)

Rea

l Int

eres

t Rat

es %

300

3

Supply of loanable funds

Demand for loanable funds

Equilibrium occurs when the quantity of loanable funds demanded equals the quantity supplied.

r

Q

Real Interest

Rate

9

DBorrowers

SLenders

Loanable Funds Market

Quantity of LoansQLoans

D1

re

r1

Q1

Example: The Gov’t increases deficit spending

Government borrows from private sectorIncreasing the demand for loans

Real interest rates increase

causingcrowding out!!

When Q dollars are lent and borrowedInvestment spending projects withA rate of return of ir % or more Are funded and those where the Rate of return is less than ir are not

Likewise, lenders who are willingTo accept an interest rate of ir% Or less will have their offers to lendFunds accepted. Equilibrium interest rate at

Shifts of Demand for Loanable Funds

Factors that can cause the demand curve for loanable funds to shift include:

• Changes in perceived business opportunities

• Changes in the government’s borrowing

Shifts in the supply of loanable funds occur as well.

Factors that cause supply shifts are:

• Changes in private savings behavior

• Changes in capital inflows.

• Student Alert!! Anything that shifts either supply demand of loanable funds curve changes the interest rate.

REMEMBER, WITH INFLATION, THERE ARE WINNERS AND LOSERS….HOW?

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REAL VERSUS NOMINAL VALUES

Nominal Values Values before an adjustment for inflation The price stated in a contract The actual price you will pay either now or

later Real Values

Values after an adjustment for inflation ‘Constant’ dollars Incorporates only productivity changes

FISHER EFFECTThe expected real interest rate is unaffected by the change in expected future inflation= lenders and

borrowers base their decisions on the expected real interest rate

Named after Irving Fisher.

THE EFFECTS OF INFLATION

FOR BORROWERS- THE TRUE COST OF BORROWING IS THE REAL INTEREST RATE NOT NOMINAL INTEREST RATE

FOR LENDERS, TRUE PAYOFF TO LENDING IS THE REAL INTEREST RATE NOT NOMINAL INTEREST RATE

FISHER EFFECT SAYS THAT AN INCREASE IN EXPECTED FUTURE INFLATION WILL DRIVE UP NOMINAL INTEREST RATES

EACH ADDITIONAL % POINT OF EXPECTED FUTURE INFLATION DRIVES UP NOMINAL INTEREST RATE BY 1% POINT.AS LONG AS THE LEVEL OF INFLATION IS EXPECTED IT DOES NOT AFFECT THE EQUILIBRIUM NOMINAL INTEREST RATE

THE FISHER EFFECT

E0

S0

D0

4

0 Q*

NominalInterest rate

Quantity of loanable funds

Demand for loanable funds

at 0% expected inflation

Demand for loanable funds

at 10% expected inflation

Supply of loanable funds

at 10% expected inflation

E10

S10

D10

14%

Supply of loanable

funds at 0%expected inflation

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DRAW GRAPHICALLYFigure Caption: Figure 29.6: The Fisher EffectD0 and S0 are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase in expected future inflation raises the equilibrium nominal interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged.

WITH A PARTNER, DRAW TWO GRAPHS THAT SHOW

CROWDING OUT AND THE FISHER EFFECT. BELOW EACH

ONE , EXPLAIN WHAT CROWDING OUT AND THE

FISHER EFFECT ARE.

TWO MODELS OF THE INTEREST RATE

KEY CONCEPTS FOR THIS MODULE-REVIEW When savers put savings in financial markets, they are

lenders because those funds are lent to borrowers thru the banking system---Dollars saved/lent are = to dollars invested/borrowed

Demand for loanable funds comes from borrowers looking to make capital investments. If real interest rate falls, more investment projects become profitable, so more funds will be demanded. Dm

Supply of loanable funds comes from savers looking to earn interest income. If Real interest rates rise-savers will forgo current consumption and save more money thus more funds will be supplied.

TELL ME AGAIN WHY WE DIFFERENT MODELS OF THE INTEREST RATE??????????

Short-term vs. long –term decisions FED determines money supply-it can put

more money in the economy but they can’t control whether it is made available for loans.

People make those decisions based on the interest rate.

Thus the difference between the vertical MS curve and upward sloping supply of loanable funds.

LAST BUT NOT LEAST

In the money market- we are concerned with short term decisions. “ how much money I need in my pocket to go shopping.”

Nominal interest rate is all that is relevant

In the long-term, there is likely to be inflation.

In the loanable funds market, we are looking at long term investments, “ How much do I need for retirement.”

2007B Practice FRQ (just do parts a and b)

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2007B Practice FRQ

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2007B Practice FRQ

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2007B Practice FRQ: Just Do the Graph for (b)

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2007B Practice FRQ

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