Loanable Funds Theory – Chapter Notes (Comprehensive)

Chapter: Loanable Funds Theory – Key Concepts and Forecasting

Chapter Objectives
- Apply the loanable funds theory to explain why interest rates change.
- Identify the most relevant factors that affect interest rate movements.
- Explain how to forecast interest rates.
Loanable Funds Theory: Overview
- The market interest rate is determined by the supply of and demand for loanable funds.
- Uses:
- Explain movements in the general level of interest rates in a country.
- Explain why interest rates among debt securities of a country vary.
- Two sides of the market: borrowers and lenders.
- Why we care about interest rates:
- They affect consumer finance decisions (housing, autos, etc.) and business investment.
Demand for Loanable Funds: Household Sector
- Households demand loanable funds to finance housing expenditures, automobiles, and household items.
- Inverse relationship between the interest rate and quantity demanded (downward-sloping demand curve).
- Distinguish between a shift of the demand curve vs. movement along the curve.
- Tax effects (illustrated by an example referenced on page 26):
- If taxes decrease, the household demand curve for loanable funds shifts to the right (increases demand).
Exhibit references (demand side)
- Exhibit 2.1: Relationship between Interest Rates and Household Demand (Dh) for Loanable Funds at a Given Point in Time.
- Exhibit 2.2: Relationship between Interest Rates and Business Demand (Db) for Loanable Funds at a Given Point in Time.
Demand for Loanable Funds: Business Sector
- Businesses demand more loanable funds at lower interest rates.
- Exhibit 2.2 illustrates the relationship between interest rates and business demand (Db).
Demand for Loanable Funds: Government Sector
- Governments demand loanable funds when planned expenditures exceed incoming revenues.
- Government demand is described as interest-inelastic: expenditures and tax policies are not highly sensitive to the level of interest rates.
- Fiscal versus monetary policy relevance in this context.
- Municipal bonds are more sensitive to rates; other government obligations (e.g., T-bills) are relatively inelastic.
- Exhibit 2.3: Impact of Increased Government Deficit on Government Demand for Loanable Funds.
Demand for Loanable Funds: Foreign Sector
- A country’s demand for foreign funds depends on the interest rate differential between currencies.
- Example: England issuing British T-bills to US investors represents foreign demand for US funds when advantageous.
- Greater interest rate differential → greater demand for foreign funds.
- The quantity of US loanable funds demanded by foreign governments is inversely related to US interest rates.
- Exhibit 2.4: Impact of Increased Foreign Interest Rates on Foreign Demand for U.S. Loanable Funds.
Aggregate Demand for Loanable Funds
- Aggregate Demand (DA) = Dh + Db + Dg + Dm + Df, where:
$DA = Dh + Db + Dg + Dm + Df$
- Dh = household demand for loanable funds.
- Db = business demand for loanable funds.
- Dg = federal government demand for loanable funds.
- Dm = municipal government demand for loanable funds.
- Df = foreign demand for loanable funds.
- Exhibit 2.5: Determination of the Aggregate Demand Curve for Loanable Funds.
Supply of Loanable Funds
- Households are the largest supplier of loanable funds, with some supply coming from government units.
- Supply increases with higher interest rates (positive slope).
- Supply can occur by households buying securities (e.g., iBonds, T-bills).
- Monetary policy effects: The Fed can affect the supply of loanable funds, thereby influencing interest rates.
- Aggregate supply of funds (SA) includes all sector supplies plus the Fed’s monetary policy actions.
- Exhibit 2.6: Aggregate Supply Curve for Loanable Funds.
Equilibrium Interest Rate: Algebraic and Graphical Presentations
- Algebraic presentation:
$DA = Dh + Db + Dg + Dm + Df$
$SA = Sh + Sb + Sg + Sm + Sf$
- Equilibrium occurs where aggregate demand equals aggregate supply at the interest rate i (i.e., $DA = SA$ ).
- Graphically (Exhibits 2.5–2.7):
- At the equilibrium interest rate i, the quantity of loanable funds supplied equals the quantity demanded.
- If the rate is above i, a surplus of loanable funds exists.
- If the rate is below i, a shortage of loanable funds exists.
- Exhibit 2.7: Interest Rate Equilibrium.
Factors That Affect Interest Rates (Overview)
- Several determinants influence where the DA and SA curves sit, thereby moving the equilibrium rate.
Factors That Affect Interest Rates (1 of 3): Growth and Inflation Effects
- Economic growth’s impact on interest rates:
- Growth puts upward pressure on rates by shifting demand for loanable funds outward (Exhibits 2.8 & 2.9).
- In good times there is more expected cash flow, causing higher demand for funds; supply may not instantly respond.
- Inflation’s impact on interest rates:
- Inflation pushes rates higher by shifting the supply of funds inward and the demand for funds outward (people borrow now before prices rise further).
- Fisher Effect:
$i = E( ext{INF}) + i_R$
- Where:
- $i$ = nominal (quoted) rate of interest.
- $E( ext{INF})$ = expected inflation rate.
- $i_R$ = real interest rate.
- Exhibit 2.8: Impact of Increased Expansion by Firms.
- Exhibit 2.9: Impact of an Economic Slowdown.
- Exhibit 2.10: Impact of an Increase in Inflationary Expectations on Interest Rates.
Factors That Affect Interest Rates (2 of 3): Monetary Policy and Budget Deficits
- Monetary policy effect:
- When the Fed reduces the money supply, it reduces the supply of loanable funds, putting upward pressure on interest rates.
- In a weak economy, the Fed may stimulate by decreasing rates, which increases the supply of loanable funds; lots of money supply leads to low rates.
- Exhibit 2.11: U.S. Interest Rates Over Time (Rate shown is for Treasury bills with a one-year maturity; shaded areas indicate recessions).
- Budget deficit impact (Crowding-out Effect):
- With a fixed amount of loanable funds, excessive government demand can crowd out private demand for funds.
- Exhibit 2.12: Flow of Funds between the Federal Government and the Private Sector.
Factors That Affect Interest Rates (3 of 3): Foreign Flows and National Currency Perspective
- Foreign flows affect rates through cross-border demand/supply of funds denominated in a currency.
- Exhibit 2.13: Demand and Supply Curves for Loanable Funds Denominated in U.S. Dollars and Brazilian Real.
- Findings:
- The USD typically sits with a large economy and curves toward the right; the Brazilian Real behaves differently depending on inflation and supply of funds.
- Higher inflation in a country may be associated with a lower supply of loanable funds at low rates and high demand even at high rates (borrow now, spend because tomorrow it’s expensive).
- Exhibit 2.13 demonstrates how equilibrium rates differ across currencies due to country-specific demand and supply dynamics.
Forecasting Interest Rates (Exhibit 2.14)
- Net Demand (ND) should be forecasted:
$ND = DA - SA$
$ND = (Dh + Db + Dm + Dr) - (Sh + Sb + Sm + Sf)$
- Future Demand for loanable funds depends on:
- Future foreign demand for U.S. funds.
- Future household demand for funds.
- Future business demand for funds.
- Future federal government demand for funds.
- Future Supply of loanable funds depends on:
- Future supply by households and others.
- Future foreign supply of loanable funds in the U.S.
- Exhibit 2.14: Framework for Forecasting Interest Rates.
Summary (1 of 3)
- The loanable funds framework shows that the equilibrium interest rate depends on the aggregate supply of funds and the aggregate demand for funds.
- As conditions change, the equilibrium shifts toward a new rate.
Summary (2 of 3): Key determinants
- Factors affecting rate movements include:
- Changes in economic growth.
- Inflation.
- The budget deficit.
- Foreign interest rates.
- The money supply.
- These factors can have a strong impact on the aggregate supply of funds and/or the aggregate demand for funds, thereby affecting the equilibrium rate.
- In particular, economic growth strongly influences the demand for loanable funds, while changes in the money supply strongly influence the supply.
Summary (3 of 3): Forecasting the rate
- Since equilibrium rate is determined by supply and demand, changes in rates can be forecasted by forecasting changes in the supply of and demand for loanable funds.
- Therefore, forecasting interest rates requires forecasting the factors that influence the supply and demand for funds.
Connections and Real-World Relevance
- The framework links macroeconomic conditions (growth, inflation, deficits) to market rates, which in turn affect consumer financing, corporate investment, and government financing.
- Monetary policy actions directly influence the fund supply, illustrating how central banks can steer rates short-term to meet macroeconomic goals.
- Understanding foreign flows is essential for exchange-rate and international capital-flow considerations.
Notable Concepts and Formulas
- Aggregate Demand for loanable funds:
$DA = Dh + Db + Dg + Dm + Df$
- Aggregate Supply of loanable funds:
$SA = Sh + Sb + Sg + Sm + Sf$
- Equilibrium condition: $DA = SA$ at the equilibrium interest rate $i$.
- Net Demand for forecasting:
$ND = DA - SA$
- Forecasting ND explicitly (expanded):
$ND = (Dh + Db + Dm + Dr) - (Sh + Sb + Sm + Sf)$
- Fisher effect (nominal rate):
$i = E( ext{INF}) + i_R$
- Elements:
- $E( ext{INF})$ = expected inflation rate.
- $i_R$ = real interest rate.
Illustrative Notes from Exhibits (referenced in the text)
- Exhibit 2.1: Household demand for loanable funds vs. interest rate.
- Exhibit 2.2: Business demand for loanable funds vs. interest rate.
- Exhibit 2.3: Government demand for loanable funds and its inelasticity.
- Exhibit 2.4: Foreign demand for U.S. funds relative to interest-rate differentials.
- Exhibit 2.5: Determination of the aggregate demand curve for loanable funds.
- Exhibit 2.6: Aggregate supply curve for loanable funds.
- Exhibit 2.7: Graphical equilibrium of interest rate.
- Exhibit 2.8–2.10: Impacts of growth, slowdown, and inflation expectations on rates.
- Exhibit 2.11: U.S. interest rates over time (with recession shading).
- Exhibit 2.12: Flow of funds between the Federal Government and the Private Sector.
- Exhibit 2.13: Demand and supply for loanable funds in USD and BRL (demonstrates currency-specific effects).
- Exhibit 2.14: Forecasting framework for interest rates.
Practical Implications and Hypothetical Scenarios
- A tax cut tends to shift household demand to the right, leading to higher equilibrium rates if supply cannot fully adjust.
- An expansion in corporate investment tends to raise the demand for loanable funds, pushing rates up, unless supply expands accordingly.
- A government budget deficit can crowd out private investment by increasing government demand for funds, raising rates unless offset by increased private saving or foreign inflows.
- A tightening monetary policy (reduction in money supply) reduces loanable funds supply, generally raising rates; in a weak economy, policymakers may ease to lower rates by expanding the money supply.
- Forecasting rates requires modeling the expected path of both private and public demand and the expected supply from households, foreigners, and the central bank.
Quick Reference Formulas
- $DA = Dh + Db + Dg + Dm + Df$
- $SA = Sh + Sb + Sg + Sm + Sf$
- $ND = DA - SA$
- $i = E( ext{INF}) + i_R$
Important Takeaway
- The equilibrium interest rate is the balance point where total demand for loanable funds equals total supply, and shifts in any component (household, business, government, foreign demand; household/business/government/foreign supply) will move the equilibrium rate toward a new level. Forecasts rely on predicting how these components will change in the future.