guided reading - Loanable funds theory

what is interest?

the price paid for the use of money

Why is interest stated as a percentage rather than a dollar amount?

so that staying the comparison of the interest paid on loans of different amounts is easier

Even though money is not capital, why does it make sense to refer to borrowed money as "money capital?"

because businesses “buy” the use of money because it can be used to acquire capital goods (for example, factories)

Rather than explaining interest rates in terms of the supply and demand for money, how does Loanable Funds Theory explain interest rates?

it explains interest rates in terms of the supply of and demand for funds available for lending (and borrowing)

In the simplified loanable funds theory, who are the following?

a. The sole suppliers of loanable funds?

b. The sole demanders of loanable funds?

a. households and consumers

b. businesses

For now, We assume that suppliers getting the funds to the demanders does not involve who or what?

financial institutions

Why does the supply curve for loanable funds slope upwards from left to right?

because households will make available a larger quantity of funds at a high interest rates than at low interest rates

what does the The Loanable Funds Graph look like?

As we have already learned from our study of investment (Ig), and as is stated here, businesses will borrow money to invest in capital if what is true regarding the interest rate and the expected rate of return?

the expected rate of interest > the interest rate

Why is the demand curve for loanable funds downward sloping from left to right?

at higher interest rates fewer investment projects will be profitable and hence a smaller quantity of loanable funds will be demanded

Since banks are paying us interest for our money and then charging businesses interest for using our money, how is it that banks profit by doing this?

they profit by changing borrowers high interest rates than the interest rates they pay savers

Even though they are different interest rates, they are both determined by what?

the supply of demand

What will cause the supply curve for loanable funds to increase or decrease (shift right or left)?

anything that causes households to be thriftier will prompt them to save more at each interest rate shifting the supply curve rightward. A decline in thriftiness would shift the curve leftward

What will cause the demand curve for loanable funds to increase or decrease (shift right or left)?

anything that increases the rate of return on potential investment will increase the demand. A decline in productivity or the price of the firms product will shift the demand leftward

In actuality, who are other demanders and suppliers of loanable funds?

a. Demander:

b. Demander:

c. Supplier:

a. government

b. businesses

c. households

How else can banks increase the supply of loanable funds?

through the lending process

If the supply of Loanable Funds increases (shifts to the right), the interest rate would INCREASE / DECREASE

increase

If the supply of Loanable Funds decreases the interest rate would INCREASE / DECREASE

decrease

If the demand for Loanable Funds increases, the interest rate would INCREASE / DECREASE?

increase

If the demand for Loanable Funds decreases, the interest rate would INCREASE / DECREASE?

decrease

Think about it. If these interactions of the supply and demand for loanable funds results in a high interest rate, MORE / LESS investment will occur leading to FASTER / SLOWER economic growth

a. less

b. slower

If the interaction of the supply and demand for loanable funds results in a low interest rate, MORE / LESS investment will occur leading to FASTER / SLOWER economic growth

a. more

b. faster

Talking about the effect that savings and interest rates have on investment (Ig) leads to the topic of 'financial capital flows' or, as it is usually simply called, 'capital flows,' and a new way to calculate Ig. Recall that businesses borrow the money needed to invest. Obviously, they cannot borrow money that is being spent. The only money that is available for businesses to borrow is money that is not being spent; that is, money that is saved. Therefore, if S = savings and Ig = Investment, then we can say that: Ig = S

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If we were to pretend that the United States was a closed economy, meaning that did not interact financially with other countries in any way, then all of the savings available to businesses would be money saved by our own citizens and our own government. These are called 'private savings' and 'public savings' respectively. Private Savings + Public Savings is called 'National Savings.'

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So in the formula, Ig = S, the S is not actually 'Savings' simply but rather 'National Savings,' the savings from this nation's citizens and government. Ig = S is the investment formula in a closed economy where S = National Savings.

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In actuality, the United States in an open economy that interacts financially with other nations. That being the case, citizens of other countries might put their money in a US bank to earn interest or in some other interest earning account in the United States. This would be an 'inflow' of savings to our country from another country. Since this new source of savings could be used by businesses to invest in capital, we refer to this inflow of savings from another country as a 'financial capital inflow' or more commonly simply as a 'capital inflow.'

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(To be sure, money is not capital. Factories, tractors, tools, and the like are capital; however, since this money is going to be used to invest in capital, we call this money 'financial capital,' 'money capital,' or simply 'capital.'). If this were the end of the story, the formula for Ig in an open economy that trades with other nations would be written as: Ig = S + capital inflows.

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However, while citizens of other nations may put their money in US banks which creates capital inflows, US citizens may also put their money in a foreign banks which creates capital outflows since this money is no longer available for US businesses to borrow. So the formula for Ig in an open economy would be: Ig = S + capital inflows - capital outflows.

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Capital inflows - capital outflows is referred to as Net Capital Inflow. So the final formula for Ig in an open economy is: Ig = S + Net Capital Inflow.

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One of the main determinants of capital flows is interest rates. If interest rates are high in another country, U.S. citizens will deposit their money in these foreign banks to earn that high interest, creating a capital outflow, decreasing Ig here but increasing it there. If interest rates are high here in the U.S., foreign citizens will deposit their money in U.S. banks, creating a capital inflow, increasing Ig here but decreasing it there.

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Why does investment equal savings?

because the only money available for businesses to borrow is money that is not being spent (money that is saved)

Write the formula for Ig in a closed economy:

Ig + S

(S = national savings)

In a closed economy, savings comes from only two sources. What are they (explain them rather than writing 'public and private savings').

in a closed economy all of the saving available to businesses would be necessary saved by our own citizens and our government. They’re called public and private savings

Using the 'econ terms' for your answers to the last question, complete the formula: investment in a closed economy is:

Ig = ____ (where S = National Savings = _______________________+ ________________________).

a. S

b. public savings

c. private savings

In an open economy that interacts financially with other nations, why would foreign citizens deposit money in a U.S. bank?

to earn interest

Since this money is now available for U.S. companies to borrow and invest, what do we call this foreign money in our banks?

financial capital inflow

Why might U.S. citizens deposit money in a foreign bank?

to earn interest

Since this money is no longer available for U.S. companies to borrow and invest, what do we call this U.S. money deposited in foreign banks?

capital outputs

What do we call capital inflows - capital outflows?

net capital inflow

Complete the formula: Investment in an open economy is:

Ig = + Net Capital Inflow (Where Net Capital Inflow = _________________ - __________________.)

a. capital inflows

b. capital outflows

The main reason that citizens deposit money where they do is what?

so they can gain capital outflows

In a closed economy, the government saves $100 and citizens save $200. What is Ig?

$300

In a closed economy, the government is in debt $50 (so -$50) and citizens save $200. What is Ig?

$150

In an open economy, the government saves $50, the citizens save $200, foreigners deposit $250 in U.S. banks and U.S. Citizens deposit $75 in foreign banks. What is Ig?

$575