Chapter 9: Savings, Interest Rates, and the Market for Loanable Funds

CHAPTER 9 - SAVINGS, INTEREST RATES, AND THE MARKET FOR LOANABLE FUNDS

Context and purpose
- Chapter 9 introduces how savers supply funds and how borrowers demand funds through the loanable funds market.
- Banks and financial institutions act as the bridge between savers (lenders) and borrowers (fisw rms/governments).
- A well-functioning loanable funds market supports investment, production of output/GDP, and overall economic growth.
- This chapter ties into prior material on savings, investment, and interest rates discussed in Chapters 6, 9, 11, and 12; anticipate a Midterm covering these chapters.
Key terms to know
- Loanable funds market: a market where savers supply funds for loans to borrowers.
- Suppliers (savers): typically households or foreign entities; save via deposits, bonds, and stocks.
- Demanders (borrowers): typically firms and governments; borrow to fund investment and production.
- Banks as the bridge: banks are the intermediary that connects savers and borrowers and earns a profit margin.
- Price in this market: the interest rate.
Why the loanable funds market matters
- A safe and well-functioning market helps savers earn a predictable return and helps borrowers access funds for investment.
- When investment is funded, it contributes to GDP and economic growth.
- The market operates like other markets: price (interest rate) coordinates saving and borrowing.
The players and what they do
- Savers: supply funds for loans (households, foreign entities).
- Borrowers: demand funds to invest in production (firms, governments).
- Banks: middlemen/bridge that facilitates saving and lending; ensure liquidity and risk management.
- Price mechanism: the interest rate acts as the price that coordinates saving and borrowing decisions.
The core dynamic
- If the interest rate is high, saving becomes more attractive, and saving supply tends to rise (incentive to save grows).
- If the interest rate is high, borrowing becomes more expensive, which reduces borrowing demand.
- The intersection of the savings supply curve and investment demand curve determines the equilibrium interest rate and the quantity of loanable funds exchanged.
Practical takeaway
- The loanable funds market explains why shifts in saving behavior or investment demand influence interest rates and overall GDP.
- Understanding shifts helps explain how policy, income changes, or life-cycle dynamics affect saving, investment, and growth.
Real-world relevance and links to other ideas
- Monetary policy and central banks influence the loanable funds market by affecting saving and borrowing conditions (e.g., target interest rates).
- Time preferences, income/wealth, and consumption smoothing from later sections interrelate with saving decisions and the supply of loanable funds.
Quick preview of the framework
- Supply of loanable funds: determined by savers’ willingness to save given the interest rate.
- Demand for loanable funds: determined by borrowers’ investment opportunities and expected returns.
- Equilibrium outcome: price (interest rate) and quantity of loanable funds; changes in either side shift the curves.
Mathematical intuition (basic)
- Let S(r) denote the savings supplied as a function of the interest rate r, and D(r) denote the investment demand as a function of r.
- Equilibrium: S(r) = D(r) at the equilibrium interest rate r*.
- A shift in S or D reflects a change in the underlying determinants (income, wealth, time preferences, etc.).
Relationship to inflation and the real rate
- The real rate is the rate after removing expected inflation; the nominal rate is what actually matters for contracts today.
- Real rate concept reminder: the real rate is what savers/borrowers care about in terms of true purchasing power of funds.
Summary connections to other content
- Real vs nominal rates: how inflation distorts the nominal rate and affects saving/borrowing incentives.
- Shifts in supply/demand: how income, wealth, time preferences, and consumption-smoothing behavior move the curves, not just movement along them.
- Life-cycle and education: long-run saving decisions are shaped by lifetime income profiles and expected returns to education.

WHAT IS THE LOANABLE FUNDS MARKET?

The loanable funds market is the arena where savers supply funds for loans to borrowers.
The market is facilitated by banks and financial institutions (the bridge).
The price mechanism is the interest rate, which coordinates saving and borrowing decisions.

THE LOANABLE FUNDS MARKET: PLAYERS AND FLOW

Savers: households or foreign entities; save via deposits, bonds, and stocks.
Borrowers: firms and governments; borrow to invest and produce output/GDP.
Banks: serve as the intermediary (the bridge) between savers and borrowers.

HOW SAVERS AND BORROWERS INTERACT

For savers, the interest rate is the return on supplying funds.
- Example (corrected): If you save $1,000 and the bank offers 5% for one year, you’ll receive $1,050 at year-end.
- Concept: the higher the rate, the more you are compensated for delaying consumption.
For borrowers, the interest rate is the cost of borrowing.
- Example: If you borrow $100,000 at 6% for one year, the annual interest is $6,000, so you repay $106,000 in total (principal plus interest).
- Investment condition: borrow and invest only if the expected return exceeds the interest cost, i.e.,
- ext{Expected Return} > ext{Interest Cost} = 100{,}000 imes 0.06 = 6{,}000.
Demand for loans falls when the interest rate rises; saving supply rises when the interest rate rises.
Real-world intuition: higher rates discourage borrowings and encourage savings; lower rates encourage borrowing and discourage saving.

REAL VS NOMINAL RATES

Definition: The real rate is the return after adjusting for inflation; the nominal rate is the rate observed in the market.
Relationship: r{ ext{nominal}} = r{ ext{real}} + ext{inflation}( ext{expected})
Significance: Savers and borrowers care about the real rate because it reflects the true purchasing power of funds.

INTEREST RATES AND INFLATION (historical perspective)

The gap between real and nominal rates reflects inflation expectations.
The historical pattern: nominal rates tend to be higher when inflation is high (e.g., 1970s).
Visual reference: a graph tracking nominal vs. real rates from 1970–2020 shows inflation driving nominal rate levels.

SHIFT IN SUPPLY AND DEMAND: REVIEW

Movement along the curve vs. shift of the curve
- Moving along the curve: a change in the quantity supplied or demanded due to a change in the current interest rate, holding other factors constant.
- Shifting the curve: a change in the entire curve due to a non-price factor (income, wealth, time preferences, etc.).
Conceptual panel takeaways (summary of what shifts do):
- Increase in demand → higher price and higher quantity in equilibrium.
- Increase in supply → lower price and higher quantity in equilibrium.
- Decrease in demand → lower price and lower quantity in equilibrium.
- Decrease in supply → higher price and lower quantity in equilibrium.

FACTORS SHIFTING SUPPLY OF LOANABLE FUNDS

Three key factors:
- Income and Wealth
- Time Preferences
- Consumption Smoothing

SHIFT IN SUPPLY: INCOME AND WEALTH

If income and wealth rise, households save more (increased incentives to save).
Foreign savings also rise as residents save more or invest abroad.
Effect: S increases; the supply curve shifts to the right.
Intuition: higher income/wealth makes saving more affordable and attractive, increasing the pool of loanable funds.

SHIFT IN SUPPLY: TIME PREFERENCES

Time preference: preference for receiving goods sooner rather than later.
Strong time preference: less patient, save less; weaker (lower) time preference: more patient, save more.
Effect: Higher time preference decreases supply of loanable funds (curve shifts left).
Example: people with strong time preference may opt for immediate consumption rather than investing in education (returns realized years later).

IT TAKES MORE TO GET MORE: EDUCATION AND EARNINGS

Pattern: education generally pays off in higher lifetime earnings.
Median annual salaries by education (2018):
- Less than high school diploma: $
  $42{,}900
- High school graduates, no college: $
  $37{,}752
- Some college or associate degree: $
  $28{,}808
- Bachelor’s degree only: $
  $61{,}724
- Advanced degree: $
  $78{,}624
Note: Higher education levels correspond to higher earnings, illustrating why midlife earnings support greater saving and thus a larger supply of loanable funds.
Possible data formatting issue in the slide (the first three figures appear counterintuitive, but the overall point remains: higher education yields higher earnings).

SHIFT IN SUPPLY: CONSUMPTION SMOOTHING (LIFE-CYCLE MOTIVATION)

Across a typical lifetime, income fluctuates: relatively low early in life, rising in prime years, falling near retirement.
People prefer to smooth consumption over their lifetime (consumption today vs. in the future).
How it works in the loanable funds market:
- Borrow early in life (e.g., education, first home) to bridge low income.
- Save during midlife when income is highest.
- Dissave in retirement, drawing down savings.
This pattern contributes to the supply of loanable funds, especially in midlife when saving is highest.

SAVINGS AND THE LIFE CYCLE (visual intuition)

A typical life-cycle profile shows: income and consumption paths, with borrowing in youth, saving in middle age, and dissaving in retirement.
Implication for the loanable funds market: supplying funds is typically strongest in midlife, shifting the supply curve to the right as more people are in their prime earning years.

SHIFT IN SUPPLY: CONSUMPTION SMOOTHING (RECAP)

Recap of key directions and explanations:
- Income and wealth increases → supply of loanable funds increases.
- Higher or more widespread midlife population → more saving → supply shifts right.
- Time preferences: lower patience (higher time preference) reduces saving; higher patience increases saving.
- Consumption smoothing over the life cycle reinforces saving in midlife and dissaving later.

SHIFTS IN SUPPLY: RECAP TABLE

Factor: Income and wealth
- Direction: Increases supply; shifts right.
- Explanation: Higher income/wealth makes saving easier and more attractive.
Factor: Time preferences
- Direction: Higher time preference decreases supply; shifts left. Lower time preference increases supply; shifts right.
- Explanation: Greater patience leads to more saving for the future.
Factor: In midlife population/prime earning years
- Direction: Increases supply; shifts right.
- Explanation: More people in the prime earning years save more.
Factor: Consumption smoothing (life-cycle)
- Direction: Overall effect is to smooth consumption across the life cycle; typically supports a rightward shift in midlife.

WHY DID AMERICAN SAVINGS SPIKE IN 2020?

Observation: The U.S. personal savings rate spiked during the COVID-19 pandemic.
Why it happened: Pandemic-related store closures and uncertainty reduced spending; households saved more instead of spending.
Aftermath: Savings rates declined somewhat as the economy reopened, but remained relatively high relative to pre-pandemic levels.
Data source: U.S. Bureau of Economic Analysis (BEA).
Simple takeaway: Uncertainty, income support, and reduced opportunities to spend temporarily increased saving, shifting the supply of loanable funds to the right.
Quick refresher: key formulas and relationships
- Real vs nominal rate relationship: r{ ext{nominal}} = r{ ext{real}} + ext{inflation}
- Investment condition for borrowers: invest if ext{Expected Return} > ext{Interest Cost} = P imes r, e.g., for P=100{,}000 and r=0.06, interest is 100{,}000 imes 0.06 = 6{,}000.
- Equilibrium condition (conceptual): S(r^) = D(r^) where S is the saving supply and D is investment demand.
Connections to broader topics
- The loanable funds framework links saving behavior, investment opportunities, and macroeconomic outcomes like GDP growth and inflation dynamics.
- The determinants of saving (income/wealth, time preferences, life-cycle consumption smoothing) tie into topics on consumer behavior and fiscal/monetary policy.
Key takeaways for the exam
- Know who saves, who borrows, and how banks facilitate the market.
- Understand the difference between shifts vs movements along the curves and the determinants of each.
- Be able to explain why higher income/wealth and longer time horizons typically increase saving.
- Be able to relate real vs nominal rates to inflation and to interpret simple examples of borrowing and saving.
- Recognize real-world patterns, such as why savings spikes can occur during periods of uncertainty or policy changes.