econ chapter 9

Savings, Interest Rates, and Loanable Funds Market

©     Loanable funds market: the market where savers supply funds for loans to borrowers.

©     Savers: households, foreign entities -> savings -> loanable funds market: banks, bonds, stocks -> loans -> borrowers: firms, governments

©     Includes places such as: stock exchanges, investment banks, mutual funds firms, commercial banks

©     Why do firms need to borrow? Most businesses cannot fund capital and other investments purchases with cash alone.

¨     Without the loanable funds market, investments would be impossible, and production and GDP would falter

·      Borrow -> prepare to produce invest and hire workers -> produce -> sell output: use revenue to pay workers and lenders

·      Every dollar borrowed requires a dollar saved

·      Lenders can’t lend money they don’t have

·      Savings provide funds for lender to lend

·      Chain of borrowing: saving -> borrowing -> investment -> output

©     Interest rates: price of loanable funds, quoted as a percentage of the original loan amount.

¨     Determined by market supply and demand

¨     Can be viewed as: the reward for saving, the cost of borrowing

©     From the savers perspective:

¨     When you save money, you are supplying funds. The price you receive in return is the interest.

¨     Example: interest rate = 3% per year, saving $500 will pay $15 for the year (500 * 0.03)

¨     Interest rate: interest/amount left (borrowed)

©     Loanable funds “law of supply”

¨     The quantity of savings rises when the interest rate increases.

©     From the borrower’s perspective: interest rate is the cost of borrowing

©     When should a firm borrow? Borrow funds if expected to return on investment is greater than the interest rate on the loan.

©     Profit-maximizing firms borrow to fund an investment if and only if the expected return on the investment is greater than the interest rate on the loan.

©     Higher the interest rate, less likely the firms are to borrow- law of demand

©     Real interest rate: the interest rate corrected for inflation

©     Nominal interest rate: the interest rate before inflation

©     Fisher equation: real interest rate = the nominal (or annual) rate – the inflation rate

©     Nominal rate = real interest rate + inflation rate

©     Supply of loanable funds: households, comes from people saving money, interest rate is a reward for saving

¨     Shift in the supply of loanable funds is caused by: changes in income and wealth, changes in time preferences, consumption smoothing

©     Demand of loanable funds: firms and government, comes from people wanting to borrow money

©     Changes in income and wealth: increases in either income or wealth generally produce increase in savings.

¨     as the world gets richer, funds make their way into the U.S loanable funds market, making borrowing easier for U.S firms.

©     Time preferences: people prefer to get goods sooner than later

¨     Weak time preferences means that someone is willing to wait for a higher consumption in the future

¨     Strong time preferences means that someone is not willing to wait long, values current consumption a lot more

©     Consumption smoothing: occurs when people borrow and save to smooth consumption over their lifetime  

©     Demanders of lonabe funds are borrowers

¨     Demand is driven by firms that need to borrow for large capital projects

¨     Governments borrow to meet their high-level spending when tax revenue isn’t enough

©     Shift in the demand of loanable funds is caused by:

¨     Changes in productivity of capital

¨     Changes in investors’ confidence

¨     Gov borrowing

©     If capital is more productive, the demand for loanable funds will increase

¨     The returns on investment will be greater

¨     Ex: internet and computers

©     Investors’ confidence: measure of what firms expect for future economic activity

¨     If a firm is more optimistic, it will borrow more today

¨     Investment demand may not even be based on rational decisions or real factors in the economy

¨     John Maynard referred investors drive to action as “animal spirits”

©     Government budget deficit and borrowing: they need to borrow money to finance their debt (from us)