Key Concepts in Loanable Funds and Monetary Policy

Market for Loanable Funds

The market where the supply of and demand for funds available for borrowing and lending are determined.

Supply of Loanable Funds

Comes from savings. Increases when people save more.

Demand for Loanable Funds

Comes from borrowing. Increases when businesses or governments borrow more.

Interest Rates

Determined by the interaction of supply and demand.

Optimism

Increases demand for borrowing → shifts demand curve right → raises interest rates.

Crowding Out

Government borrowing increases interest rates, reducing private investment.

Expansionary Fiscal Policy

Occurs when increased government spending leads to higher interest rates.

Diversification

Reducing risk by spreading investments across various assets.

Example of Diversification

Mutual funds create portfolios to diversify investments for clients.

Expansionary Monetary Policy in Recession

Goal: Increase aggregate demand, real output, and employment.

Tools of Expansionary Monetary Policy

Lower interest rates, buy Treasury securities, reduce reserve ratio.

Lower Discount Rate

Makes borrowing cheaper for banks.

Open Market Operations

Buying Bonds: Adds money to the banking system.

Lower Reserve Ratio

Allows banks to loan more.

M1

Most liquid (currency, demand deposits, traveler's checks).

M2

Includes M1 + near money (savings accounts, small time deposits).

Fiat Money

Backed by government decree, not a physical commodity.

Excess Reserves

Reserves held by banks beyond the required amount.

Increase in Excess Reserves

Occurs when reserve ratio decreases or Fed injects money into the economy.

Money Demand (MD)

Shifts when economic activity changes (e.g., GDP changes).

Money Supply (MS)

Controlled by the Fed; vertical line.

Private Saving Formula

Private Saving = GDP − Consumption − Taxes

Government Budget Balance Formula

Budget Balance = Taxes Collected − Government Spending

Surplus

Positive balance.

Deficit

Negative balance.

National Saving Formula

National Saving = Private Saving + Public Saving (Budget Balance)

Interest Calculation

Future Value = Principal × (1 + r)

Reserve Ratio

Reserve Ratio = (Reserves / Deposits) × 100

Excess Reserves Calculation

Excess Reserves = Total Reserves − Required Reserves

Required Reserves

Required Reserves = Deposits × Reserve Ratio

Change in Money Supply

Change in Money Supply = Excess Reserves × Money Multiplier

Money Multiplier

Money Multiplier = 1 / Reserve Ratio

Total Assets Equation

Total Assets = Total Liabilities + Equity