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

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Disequilibrium in the loanable funds market

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• 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

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

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• 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

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

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• 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

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