Unit 4.7: Financial Sector

The Loanable Funds Market

• Loanable Funds market (loans)::
    * How much money in the form of loans consumers, businesses, and government are requiring
      * Determined by expectation of return on investment
• Real interest rate::
    * The “price of borrowing money”
    * with loanable funds, use real instead of nominal b/c loans are usually taken over a longer period of time
    * ^^Real interest rate = nominal interest rate - inflation rate^^
• Demand for loans
    * Follows the law of demand like any other good/service (downsloping)
    * Represents the amount of loans being demanded by consumers, producers, and government
• Supply of loans
    * Follows the law of supply like any other good/service (upsloping)
    * In a closed economy:
      * ^^Supply in closed economy = national savings^^
      * ^^national savings = public + private savings^^
    * In an open economy
      * ^^Supply in open economy = national savings + net capital inflow^^ (money coming in from foreign investors)
• Equilibrium
    * Occurs when the interest rate is set where quantity supplied = quantity demanded

Disequilibrium in the loanable funds market

• Left graph:
    * Real interest rate is below the equilibrium
      * Shortage of loans
        * demand will go up and supply will go down
        * borrowing will be more cheap (high demand)
        * less payoff for saving
          * People won’t keep as much money in the bank so the amount available to loan out decreases (low supply)
      * Must increase interest rate from IR2 to IRe
• Right graph:
    * Real interest rate is above the equilibrium
      * Surplus of loans
        * demand will go down and supply will go up
        * borrowing will be more expensive (low demand)
        * more payoff for saving
          * People will keep more money in the bank so the amount available to loan out increases (high supply)
      * Must decrease interest rate from IR2 to IRe

Changes in ^^demand^^ of loanable funds: shifted by changes in return on investment

• Left graph:
    * Higher expected return on investment, economy doing well, higher income, etc
      * Demand for loans increases (shifts right)
      * Equilibrium interest rate increases
• Right graph:
    * Lower expected return on investment, recession, people losing jobs, etc
      * Demand for loans decreases (shifts left)
      * Equilibrium interest rate decreases

Changes in ^^supply^^ of loanable funds: shifted by changes in savers’ behavior

• Saving refers to people keeping their money in banks instead of spending it
• Left graph:
    * Saving increases
      * supply for loans increases (shifts right)
      * Equilibrium interest rate decreases
• Right graph:
    * Saving decreases
      * supply for loans decreases (shifts left)
      * Equilibrium interest rate increases