Notes on Chapter 4. Loanable Funds and the Real Interest Rate. ECON 141: Macroeconomics Loanable Funds Dr. Mohammed Alwosabi

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1 Notes on Chapte 4 Loanable Funds and the Real Inteest Rate 1 Potential GDP depends on the quantity of poductive esouces. Thus, the gowth ate of PGDP depends on how apidly the esouces gow. One of the majo esouces that is impotant to gow is the economy's capital stock. The capital stock includes business capital as well as inventoies. The economy's capital stock is measued by its total physical quantity and quality of plants, machines, equipments, buildings, inventoies of aw mateials and semifinished goods, highways, schools, 2 etc. In addition to the pivately owned capital stock esulting fom pivate investment (business investment plus investment in new homes and additions to inventoies), we also have publicly owned capital stock in the fom of social infastuctue capital (highways, dams, schools), which is pimaily ceated by govenment investment. The capital stock is detemined by investment decisions. The funds that finance investment ae obtained in the maket fo loanable funds.3 The maket fo loanable funds is the maket in which households, fims, govenments, banks, and othe financial institutions boow and lend. To undestand the investment and the saving decisions in the loanable funds maket, we have to undestand the meaning and the function of the inteest ate and distinguish between nominal inteest ate and eal inteest ate. Classical theoy teated saving as a diect function of the ate of inteest and investment as an invese function. 4 INTEREST RATE Inteest ate is the pice of fund (the cost of loan), usually expessed as an annual pecentage. The ate is deived by dividing the amount of inteest by the amount of money boowed. Example: If a bank chaged $50 a yea to boow $1,000, the inteest ate would be 5%. 5 The nominal inteest ate (i) is the amount of money that a unit of capital eans. It is the actual amount paid as inteest pe unit of cuency boowed fo each peiod. When people boow money fom a bank, the bank chages the nominal inteest ate. When you buy a ca fom a deale and pay by installments, the deale chages you the nominal inteest ate. Investment, saving and consumption all depend on eal inteest ate () athe than nominal inteest ate (i). 6 1

2 The eal inteest ate () is the quantity of goods and sevices that a unit of capital eans. It is nominal inteest ate adjusted fo inflation. The eal inteest ate () = nominal inteest ate (i) - inflation ate Thus, the nominal inteest ate = eal inteest ate () + inflation ate 7 Example: Suppose a bank has made a one-yea loan of 1000 dinas with nominal inteest ate = 5%. At the end of the yea, the bank would eceive 1050 (100 * 1.05). That is, the bank gained 5%. Suppose the inflation ate of that yea = 4%. The bank eal gain o eal inteest ate = 5% -4% = 1% Execise: If eal inteest ate is 5 % and inflation ate is 4 %. What would be the nominal inteest 8 ate? Uses and Resouces of Loanable Funds Loanable funds ae used in thee puposes: Business investment Govenment budget deficit Intenational investment o lending Loanable funds come fom thee esouces: Pivate saving Govenment budget suplus Intenational boowing How Investment Is Financed? Financial makets ae used to finance deficits, pay fo investment, and save. Investment is financed fom thee souces: 1. Pivate saving (S), is the amount that households have left afte they have paid thei taxes and bought thei consumption goods and sevices 2. Public Saving (T G), which is the govenment budget suplus 3. Boowing fom the est of the wold (M X) We can see these thee souces of investment finance by using the fact that aggegate expenditue equals aggegate income. Households income is consumed, saved, o paid in taxes: Y = C + S + T Theefoe, RGDP can be witten as; Y = C + I + G + X - M (eflecting its aggegate expenditue), o Y = C + S + T (eflecting the use of RGDP, income) 11 So we have C + I + G + (X M) = C + S + T Cancel the C's and move X - M to the financing side you get I + G = S + T + (M X) This equation shows us that financing fo I and G come fom pivate saving, taxes, and foeign souces. Move G to the financing side and you have I = S + (T G) + (M X) This fomula shows that investment is financed using saving, a govenment budget suplus, (T G) and boowing fom the est of the wold, (X M) 12 2

3 Pivate saving (S) = Y T C = disposable income consumption = income tax consumption Govenment (Public) saving = T G If (T G) > 0 suplus If (T G) < 0 deficit National saving = pivate saving + govenment saving = (Y T C) + (T G) = Y C G Pivate investment = National Saving + boowing fom the est of the wold 13 Example: Suppose an economy has the following data (in million of dollas) Y = 200, C = 130, T = 30, and G = 20, then Pivate Saving = S = Y C T = = 40 Public saving = T G = = 10 National saving = Y C G = = 50, o = pivate saving + public saving = = Execise: If you have the following data: govenment saving = 0, RGDP = $2500 million, pivate consumption = $1300 million, tax = $350 million; calculate the county s national saving Execise: If national saving is $200,000, net taxes equal $100,000 and govenment puchases of goods and sevices ae $50,000, how much ae households and businesses saving? 15 The Demand fo Loanable Funds The quantity of loanable fund demanded (quantity of LFD) is the total quantity of funds demanded to finance investment, the govenment budget deficit, and intenational investment o lending duing a given peiod. This quantity depends on 1. The eal inteest ate 2. The expected pofit ate 3. Govenment and intenational factos 16 The demand fo loanable funds (DLF) is the elationship between the quantity of loanable funds demanded and the eal inteest ate when all othe influences in boowing plans emain the same. Business investment (I) is the main component of loanable funds. Othe things emaining the same, investment (quantity of eal loanable funds demanded) deceases if the eal inteest ate () ise and inceases if the eal inteest ate () fall. 17 Fom the above discussion, it should be clea that the demand fo loanable funds (DLF) cuve is downwad sloping, showing the negative elationship between the eal inteest ate () and the quantity of loanable funds demanded. 18 3

4 A change in esults in a movement along the DLF (ID) cuve. If, LF and thee is an upwad movement along the DLF cuve. If, LF and thee is a downwad movement along the DLF cuve. Thus a change in the eal inteest t ate bings a change in investment and a change in the quantity of loanable funds demanded, which is shown by a movement along loanable funds demand cuve (%) DLF DLF0 DLF1 LF Execise: Conside the following table Yea i Inflation ate Which yea the county was expected to have the highest investment in? 2. In 2001, the fim thought to invest $10000 in a poject and the expected annual evenue is $300. What is the expected net pofit? Should the fim do the poject? 21 Changes in demand fo loanable funds (Shifts of DLF cuve) A change in any othe influence on a fim s decision to invest and boow funds is shown by a shift of a demand cuve. These othe influences ae all the factos that affect a fim s expected pofit. When the expected pofit changes investment demand changes and loanable funds change. 22 Othe things emaining the same, the geate the expected pofit ate fom the new capital the geate is the amount of investment and the geate is the demand fo loanable funds; and the loanable funds demand cuve shifts ightwad to DLF 1. When the expected pofit deceases, investment demand deceases and the loanable funds demand cuve shifts leftwad to ID 2. The main factos that affect the expected pofit ate ae 1. Advances in technology: With the technological advances, pofits ae expected to incease in the long un. 2. The phase of the business cycle: Duing expansion, an incease in sales bings a highe pofit ate; in ecession, a decease in sales bings a lowe pofit ate. 3. Taxes: Changes in tax ates influence the fim's afte-tax pofit ate

5 Changes in the expected pofit ate appea to be moe impotant than changes in the eal inteest ate in contibuting to changes in the amount of investment in the economy (i.e., shifts in the loanable funds demand cuve ae moe impotant than movements along the cuve). 25 The Supply of Loanable Funds The quantity of loanable funds supplied is the total funds available fom pivate saving, the govenment budget suplus, and intenational boowing duing a given peiod. This quantity depends on 1. The eal inteest ate 2. Disposable income 3. Wealth 4. Expected futue income 5. Govenment and intenational factos 26 The eal inteest ate and the quantity loanable funds supplied (Movements along the Supply of loanable funds cuve) The supply of loanable funds (SLF) is the elationship between the quantity of loanable funds supplied and the eal inteest ate, othe things emaining the same. Saving is the main item that makes up the supply of loanable funds. 27 Thee is a positive elationship between eal inteest ate and the quantity of saving, and, theefoe, thee is a positive elationship between eal inteest ate and quantity loanable funds supplied. Othe things emaining the same, the highe the eal inteest ate the geate is the saving (the geate is the quantity loanable funds supplied); and the lowe the eal inteest ate, the smalle is the saving (the smalle is the quantity loanable funds supplied). 28 A change in eal inteest ate esults in a movement along the same SLF cuve, othe things emaining the same. If S upwad movement along SLF cuve. If S downwad movement along SLF cuve. Saving inceases when the eal inteest ate inceases because is the oppotunity cost of consumption. The supply of loanable funds cuve (SLF) is upwad sloping, showing the positive elationship between the eal inteest ate and the quantity of loanable funds supplied. 29 Changes in the Supply of Loanable (Shifts of the SLF cuve): When any influence on saving othe than the eal inteest ate changes, saving supply changes and SLF cuve shifts. The thee main factos that influence saving supply ae: (1) Disposable Income: An incease in household s disposable income people save moe at each eal inteest ate an incease in S and a shift of SLF cuve to the ight. 30 5

6 SLF2 SLF0 SLF1 (2) Wealth: A household wealth equals its assets (what it owns) minus its debt (what it owes). The puchasing powe of household s wealth is the eal value of its wealth. It is the quantity of goods and sevices that the household s s wealth can buy. A decease in wealth people save moe at each eal inteest ate an incease in SLF and a shift of SLF cuve to the ight Loanable Funds (3) Expected futue income: A decease in the expected futue income people save moe at each eal inteest ate an incease in SLF and a shift of SLF cuve to the ight A decease in disposable income, an incease in wealth, o an incease in expected futue disposable income deceases saving supply and shifts the SLF cuve leftwad. EQUILIBRIUM IN FUND MARKET (Detemination of the Real Inteest Rate) 2 1 * SLF DLF 33 I* = S* Loanable funds 34 As have been seen, othe things emaining the same, the quantities of loanable funds demanded and supplied depends on the eal inteest ate. The highe the eal inteest ate, the geate is the amount of saving and the lage is the quantity of loanable funds supplied, and the smalle is the amount of investment and the smalle is the quantity of loanable funds demanded. Thee is one inteest ate at which the quantities of loanable funds demanded and supplied ae equal, and that is the equilibium eal inteest ate. The DLF cuve and the SLF cuve intesection detemine the equilibium eal inteest ate (*). The financial maket is in equilibium when is such that the quantity of LFS equals the quantity of LFD

7 Thee is neithe a suplus no a shotage of saving so that investos can get the funds they demand and saves can lend all the funds they have available. Thee is one inteest ate at which the quantities of loanable funds demanded and supplied ae equal, and that is the equilibium eal inteest ate. The DLF cuve and the SLF cuve intesection detemine the equilibium eal inteest ate (*). If > * the amount of loanable funds supplied > the amount of loanable funds demanded suplus of funds available (suplus of loans) lendes will be unable to find boowes willing to boow all of the available funds and to * the quantity of loanable fund demanded ises and the quantity of loanable funds supplied falls until the two ae bought into equilibium If < * the quantity loanable funds supplied < the quantity loanable funds demanded shotage of the funds available (boowes can't find the loans they want, but lendes ae able to lend all the funds they have available) to * Changes in the Real Inteest Rate (Shifts in DLF and SLF) (a) If any of the factos that influences investment changes, investment would change and DLF cuve shifts. If fims expect highe net pofit DLF cuve shifts ightwad and the equilibium quantity of loanable funds SLF (b) If any facto that affects saving changes, saving would change and SLF cuve would shift. If people's disposable income SLF cuve shifts ightwad and the equilibium quantity of loanable funds. 1 * DLF1 DLF0 I* = S* I1, S1 LF

8 * 1 SLF0 SLF1 (c) If both I and S both DLF and SLF cuves shifts ightwad the amount of loanable funds but may, o stay the same. (it depends on the size of the shifts of both DLF and SLF). (Remembe the discussion in Ch.3 about the diffeent types of shifts of both AD and SAS). DLF0 I* = S* I1, S1 LF SLF0 SLF1 * DLF0 DLF1 LF I* = S* I1, S