Market for Loanable Funds Graph---AP Macroeconomics

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The Market For Loanable Funds : The Market For Loanable Funds We will use a basic Supply and Demand Graph to analyze this market The Market for Loanable Funds is NOT a real place. It is a composite representation of the financial market/system where: 1. people/businesses/governments WITH money supply it to others, and inreturn get an interest rate they EARN for supplying that money. 2. People/businesses/government s WITHOUT money borrow it from others, and in return get an interest rate they PAY for demanding that money. 1

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 2

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds When Consumers/Businesses or Governments have surplus Funds they may want to Place them in some type of Savings and/or Investment 3

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds This surplus savings is put Into the financial system As a SUPPLY of Loanable Funds 4

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds What these savers/investors care about Is the REAL INTEREST RATE they will Earn on their money. Remember the Real Interest Rate is what You will earn AFTER inflation is factored out 5

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds What these savers/investors care about Is the REAL INTEREST RATE they will Earn on their money. Remember the Real Interest Rate is what You will earn AFTER inflation is factored out 6 Real Interest Rate = Nominal Interest Rate - Inflation

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 7 The Demand for Loanable Funds comes From Consumers/Business/Governments Who don’t have money, but want to borrow It to finance their purchases

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 8 What these BORROWERS care about Is the REAL INTEREST RATE they will PAY on the money they BORROW. Remember the Real Interest Rate is what You will earn AFTER inflation is factored out

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 9 What these BORROWERS care about Is the REAL INTEREST RATE they will PAY on the money they BORROW. Remember the Real Interest Rate is what You will earn AFTER inflation is factored out Real Interest Rate = Nominal Interest Rate - Inflation

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds The REAL INTEREST RATE is a Long-Term interest rate that both Borrowers AND savers are going to consider when making decisions 10

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 11 The Struggle Ensues…. Demanders for Loanable Funds desire a LOWER Real Interest Rate because for : 1. Consumers it makes the purchases of houses, Cars, Big Screen T.V.’s, etc LESS expensive

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 12 The Struggle Ensues…. Demanders for Loanable Funds desire a LOWER Real Interest Rate because for : 1. Businesses it makes the purchases of Capital Goods, expanding facilities, or building new facilities LESS expensive

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 13 The Struggle Ensues…. Demanders for Loanable Funds desire a LOWER Real Interest Rate because for : 1. Businesses it makes the purchases of Capital Goods, expanding facilities, or building new facilities LESS expensive VITALLY IMPORTANT POINT!! Therefore, for BUSINESSES it makes Projects they take on MORE profitable. New business investment tends to ADD To the CAPITAL STOCK of an Economy

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 14 The Struggle Ensues…. The SUPPLIERS of Loanable Funds desire a HIGHER Real Interest Rate because it makes the Money they saved/invested GROW LARGER .

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 15 Assume the Market for Loanable Funds is In equilibrium at “r*”. At this Real Interest Rate Demanders will demand QLF* and Suppliers will supply QLF*. This is the Market clearing “price”.

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 16 ASSUMPTION Assume the U.S. Government pursues an Expansionary Fiscal Policy that requires it to Deficit spend (spend MORE than they bring In in Tax Revenue.

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 17 In order to do this they will need to BORROW Money (assuming they don’t just print it). The U.S Government will enter the Market for Loanable Funds as a DEMANDER (remember, They don’t have money, they want it).

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 18 This policy will INCREASE the Demand for Loanable Funds QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT )

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 19 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*)

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 20 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*) The REAL INTEREST RATE INCREASED Because of Government Deficit Spending!!!

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 21 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*) The REAL INTEREST is HIGHER than Before, so NOW for Consumers and/or Businesses to BORROW will be MORE Expensive due to the new Government policy

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 22 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*) This reduction in Consumer/Business borrowing because of Govt. deficit spending is Called “THE CROWDING OUT EFFECT” of PRIVATE SPENDING . (C + I)

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 23 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*) This is illustrated by the difference between the two equilibrium rates

PowerPoint Presentation : Real Interest Rate Quantity of Loanable Funds r* QLF* Demand for Loanable Funds* (Consumers/Businesses) Supply of Loanable Funds* (Consumers/Businesses/Governments) Market for Loanable Funds 24 QLF₁ r₁ DLF₁ (Consumers/Businesses AND GOVERNMENT) The Market for Loanable Funds Establishes a NEW equilibrium (r₁) HIGHER then the previous Equilibrium point (r*) How much The Crowding Out Effect impacts the economy is dependent upon how responsive Consumers and Businesses are to changes in The REAL INTERERST RATE

“CROWDING OUT EFFECT” of Government Spending : “CROWDING OUT EFFECT” of Government Spending If consumers and business are HIGHLY responsive to increases in interest rates then the Crowding Out Effect on Govt. spending will be “COMPLETE Crowding Out Effect” If consumers and business are partially responsive to increases interest rates then the Crowding Out Effect of Govt. spending will be “Partial Crowding Out Effect” If consumers and businesses are NOT responsive to changes in interest rates then there will be No Crowding Out Effect of Govt. spending. 25

Crowding Out Effect and AD/AS : Crowding Out Effect and AD/AS 26 Price Level Real GDP FE GDP SRAS LRAS AD* AD/AS is indicating the Economy is in a severe Recession. Assume Govt. Spending INCREASES (through BORROWING) And the economy returns To Full-Employment RGDP RGDP* PL* PL₁ AD₁ This would suggest that C + I are NOT RESONSIVE to the INCREASE i n the REAL INTEREST RATE. Borrowing by C + I would not be effected---” NO CROWDING OUT EFFECT” Actual RGDP = Potential RGDP

Crowding Out Effect and AD/AS : Crowding Out Effect and AD/AS 27 Price Level Real GDP FE GDP SRAS LRAS AD* AD/AS is indicating the Economy is in a severe Recession. Assume Govt. Spending INCREASES (through BORROWING) And the economy DOES NOT Return to Full-Employment RGDP. RGDP* PL* PL₁ AD₁ This would suggest that C + I are PARTIALLY RESPONSIVE to the INCREASE i n the REAL INTEREST RATE. Borrowing by C + I would be NEGATIVELY effected---” PARTIAL CROWDING OUT EFFECT” Actual RGDP < Potential RGDP RGDP₁

Crowding Out Effect and AD/AS : Crowding Out Effect and AD/AS 28 Price Level Real GDP FE GDP SRAS LRAS AD* AD/AS is indicating the Economy is in a severe Recession. Assume Govt. Spending INCREASES (through BORROWING) And the economy STAYS THE SAME. Any increase in Govt. Spending is off-set COMPLETLEY By the decreases borrowing By consumers and businesses. RGDP* PL* PL₁ AD₁ This would suggest that C + I are 100% RESPONSIVE to the INCREASE i n the REAL INTEREST RATE. Borrowing by C + I would be 100% NEGATIVELY effected- --”COMPLETE CROWDING OUT EFFECT” Actual RGDP < Potential RGDP

JUST SO WE ARE CLEAR ABOUT “CROWDING OUT EFFECT” : JUST SO WE ARE CLEAR ABOUT “CROWDING OUT EFFECT” If Government INCREASES deficit spending and by doing so INCREASES the REAL INTEREST RATE then it may have the following effects: No Crowding out effect: Govt. spends and it DOES NOT effect borrowing by C + I and the economy can return to Full-Employment Partial Crowding Out: Govt. spends and it DOES effect borrowing by C + I. C + I do not borrow AS MUCH thus potentialLY causing the economy to NOT RETURN TO FULL EMPLOYMENT. Complete Crowding Out: Government Spends and it has the effect of causing C + I to NOT borrow and the economy virtually stays the same: NO INCREASE RGDP 29

ONE LAST IMPORTANT CONNECTION : ONE LAST IMPORTANT CONNECTION If interest rates increase due to Government borrowing AND if it “crowds out” PRIVATE INVESTMENT in the business sector the following could happen: Capital projects (expanding facilities, building new facilities) will become less profitable. Business will not borrow to replace capital equipment. Short term Aggregate Demand will be adversely affected. Long Run Aggregate Supply (PPF) will be adversely affected because the CAPITAL STOCK of the economy will become obsolete and/or depleted. Essentially Capital Stock will DECREASE. 30

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