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Economics: Paul Krugman - Robin Wells

The document discusses the market for loanable funds, which examines the demand for funds from borrowers and the supply of funds from lenders. It explains how the interest rate is determined at the equilibrium point where the quantity of loanable funds demanded equals the quantity supplied. The determinants of demand and supply are described, including how shifts in either curve affect the equilibrium interest rate. Factors like inflation expectations, government borrowing, and private savings are explained as influencing loanable funds and interest rates. The relationship between nominal and real interest rates, known as the Fisher effect, is also covered.

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476 views23 pages

Economics: Paul Krugman - Robin Wells

The document discusses the market for loanable funds, which examines the demand for funds from borrowers and the supply of funds from lenders. It explains how the interest rate is determined at the equilibrium point where the quantity of loanable funds demanded equals the quantity supplied. The determinants of demand and supply are described, including how shifts in either curve affect the equilibrium interest rate. Factors like inflation expectations, government borrowing, and private savings are explained as influencing loanable funds and interest rates. The relationship between nominal and real interest rates, known as the Fisher effect, is also covered.

Uploaded by

henry
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 23

ECONOMICS

SECOND EDITION in MODULES

Paul Krugman | Robin Wells


with Margaret Ray and David Anderson
MODULE 29
The Market for Loanable Funds

Krugman/Wells
• How the loanable funds
market matches savers and
investors
• The determinants of supply
and demand in the loanable
funds market
• How the two models of
interest rates can be
reconciled

3 of 23
The Market for Loanable Funds

• The loanable funds market is a hypothetical market that


examines the market outcome of the demand for funds
generated by borrowers and the supply of funds
provided by lenders.
• The interest rate is the price, calculated as a percentage
of the amount borrowed, charged by the lender to
a borrower for the use of their savings for one year.

4 of 23
The Monetary Role of Banks
The Market for Loanable Funds
• The rate of return on a project is the profit earned on the
project expressed as a percentage of its cost.

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The Demand for Loanable Funds

Interest
rate

A
12%

B
4

Demand for loanable funds, D

0 $150 450 Quantity of loanable funds


(billions of dollars)
6 of 23
The Supply for Loanable Funds

Interest
Supply of loanable funds, S
rate

12%
Y

4
X

0 $150 450 Quantity of loanable funds


(billions of dollars)
7 of 23
Equilibrium in the Loanable
Funds Market
Interest
rate
Projects with rate of return
8% or greater are funded.

12%
Offers not accepted from
lenders who demand interest
rate of more than 8%.

r* 8
Projects with rate of return
less than 8% are not funded.

Offers accepted from lenders


willing to lend at interest rate
of 8% or less.
0
$300 Quantity of loanable funds
Q* (billions of dollars) 8 of 23
Shifts of the Demand for
Loanable Funds
• Factors that can cause the demand curve for loanable
funds to shift include:
– Changes in perceived business opportunities
– Changes in the government’s borrowing

• Crowding out occurs when a government deficit drives


up the interest rate and leads to reduced investment
spending.

9 of 23
An Increase in the Demand for
Loanable Funds
Interest
rate

An increase in the
demand for loanable
r funds . . .
2
. . . leads to a rise
in the equilibrium
interest rate. r
1

D
2
D
1
Quantity of loanable funds
10 of 23
Shifts of the Supply of
Loanable Funds

• Factors that can cause the supply of loanable funds to


shift include:
– Changes in private savings behavior: Between 2000 and
2006 rising home prices in the United States made many
homeowners feel richer, making them willing to spend
more and save less. This shifted the supply of loanable
funds to the left.
– Changes in capital inflows: The U.S. has received large
capital inflows in recent years, with much of the money
coming from China and the Middle East. Those inflows
helped fuel a big increase in residential investment
spending from 2003 to 2006. As a result of the worldwide
slump, those inflows began to trail off in 2008.
11 of 23
An Increase in the Supply of
Loanable Funds
Interest
rate
S
1
S
2

r
… leads to a 1
fall in An increase in the
equilibrium supply for loanable
interest rate. funds . . .
r
2
D

Quantity of loanable funds

12 of 23
Inflation and Interest Rates

• Anything that shifts either the supply of loanable funds


curve or the demand for loanable funds curve changes
the interest rate.
• Historically, major changes in interest rates have been
driven by many factors, including:
– changes in government policy
– technological innovations that created new investment
opportunities

13 of 23
Inflation and Interest Rates

• However, arguably the most important factor affecting


interest rates over time is changing expectations about
future inflation.
• This shifts both the supply and the demand for loanable
funds.
• This is the reason, for example, that interest rates today
are much lower than they were in the late 1970s and
early 1980s.

14 of 23
Inflation and Interest Rates

• Real interest rate = nominal interest rate - inflation rate

• In the real world neither borrowers nor lenders know


what the future inflation rate will be when they make a
deal. Actual loan contracts, therefore, specify a nominal
interest rate rather than a real interest rate.

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The Fisher Effect

• According to the Fisher effect, an increase in expected


future inflation drives up the nominal interest rate,
leaving the expected real interest rate unchanged.

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The Fisher Effect

Nominal Demand for loanable funds Supply of loanable funds


Interest rate at 10% expected inflation at 10% expected inflation

S
10
E
10
14%

Supply of loanable D
Demand for loanable funds 10
at 0% expected inflation funds at 0%
expected inflation S
0

4
E
0
D
0

Q* Quantity of loanable funds


0 17 of 23
Reconciling the
Two Interest Rate Models
• The Interest Rate in the Short Run
– According to the liquidity preference model, a fall in the
interest rate leads to a rise in investment spending, I,
which leads to a rise in real GDP and
consumer spending, C.
– Increasing GDP also leads to an increase in Saving
because of the savings-investment spending identity.
– After a decrease in the interest rate, the quantity of
savings supplied rises exactly enough to match the
quantity of savings demanded.

18 of 23
The Short-run Determination of
the Interest Rate

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Reconciling
the Two Interest Rate Models
• The Interest Rate in the Long Run
– In the long run, changes in the money supply don’t affect
the interest rate.

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The Long-run Determination of
the Interest Rate

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1. The hypothetical loanable funds market shows how
loans from savers are allocated among borrowers with
investment spending projects.
2. In equilibrium, only those projects with a rate of return
greater than or equal to the equilibrium interest rate
will be funded.
3. Government budget deficits can raise the interest rate
and can lead to crowding out of investment spending.
4. Changes in perceived business opportunities and in
government borrowing shift the demand curve for
loanable funds; changes in private savings and capital
inflows shift the supply curve.
22 of 23
5. Because neither borrowers nor lenders can know the
future inflation rate, loans specify a nominal interest
rate rather than a real interest rate.
6. For a given expected future inflation rate, shifts of the
demand and supply curves of loanable funds result in
changes in the underlying real interest rate, leading to
changes in the nominal interest rate.
7. According to the Fisher effect, an increase in expected
future inflation raises the nominal interest rate one-to-
one so that the expected real interest rate remains
unchanged.

23 of 23

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