AP Macroeconomics The Loanable Funds Market
Loanable Funds Market The market where savers and borrowers exchange funds (Q LF ) at the r%. The D for LF, or borrowing comes from HH, firms, G and the foreign sector. The D for LF is also the S of bonds. (people want to borrow or have bonds printed) The S of LF, or savings comes from hh, firms, G and the foreign sector. The supply of LF is also the D for bonds. (people want to put $ into savings or buy bonds)
Loanable Funds Market in r% Equilibrium S LF & D Bonds r D LF & S Bonds q Q LF
Changes in the D for LF Remember that D for LF = borrowing (i.e. S bonds) More borrowing = more D for LF ( ) Less borrowing = less D for LF ( ) Examples Government deficit spending = more borrowing = more demand for loanable funds.: D LF.: r% Less investment demand = less borrowing = less demand for loanable funds.: D LF.: r%
r% Increase in the Demand for Loanable Funds S LF r 1 r D LF D LF 1 q q 1 Q LF D LF.: r% & Q LF
Decrease in the Demand r% for Loanable Funds S LF r r 1 D LF 1 D LF q 1 q Q LF D LF.: r% & Q LF
Changes in the Supply of Loanable Funds Remember that S of LF = saving (i.e. D for bonds) More saving = more S of LF ( ) Less saving = less S of LF ( ) Examples Government budget surplus = more saving = more supply of loanable funds.: S LF.: r% Decrease in consumers MPS = less saving = less supply of loanable funds.: S LF.: r%
r% Increase in the Supply of Loanable Funds S LF S LF 1 r r 1 D LF q q 1 Q LF S LF.: r% & Q LF
Decrease in the Supply of r% Loanable Funds S LF 1 S LF r 1 r D LF q 1 q Q LF S LF.: r% & Q LF
Final thoughts on Loanable Funds LF market determines the r% LF market relates saving and borrowing. Changes in saving and borrowing create changes in LF and.: the r% changes. When government does fiscal policy it will affect the LF market. Changes in the r% will affect Gross Private Investment
As the r% changes, the quantity of Investment Demanded changes r% (As compared to the expected rate of return) Other determinants that shift the ID curve: costs of capital business taxes Technology expectations ID Q Investment Demand
RIR r1 S LF D LF Supply of Loanable Funds: personal savings and financial capital from abroad Demand for Loanable Funds: firms demand for funds for capital and interest sensitive consumption Q1 Q Loanable Funds Market
Effect of Expansionary Fiscal Policy on Loanable Funds & Investment r% S LF r% r 1 r D LF D LF 1 I D q q 1 Q LF G and/or T.: Government deficit spends.: D LF.: r%.: I G (Crowding-Out Effect) I 1 I I G
The Sale/Purchase of Bonds and the interest rate If the Fed buys bonds, there is more $ in the MS and therefore people don t borrow and loans become cheap (lower r%) Buy Bonds = Big Bucks Sell bonds = small Bucks The Fed targets the Fed Funds Rate by buying & selling bonds. Buying bonds means bigger supply of money and lower Fed Funds Rate.
THE CROWDING-OUT EFFECT An increase in the government s deficit shifts to demand curve for loanable funds to the right, which leads to a higher interest rate. If the interest rate rises, businesses will cut back on their investment spending. So, a rise in the government budget deficit tends to reduce overall investment spending. This negative effect of government budget deficits on investment spending is called crowding out.
Loanable Funds Market Graph Recap (Long-Term Interest Rates) What changes Supply: 1. Increase in Household savings 2. Increase in Gov t savings 3. Increase in Business savings 4. Increase in Foreigners savings What changes Demand: 1.Increase in Household borrowing 2.Increase in business Investment 3.Increase in Foreign borrowing 4.Increase in Government borrowing (When the gov t has a budget deficit!) = (the crowding -out effect)
Q s from the AP Exam 1. Using a correctly labeled graph of the loanable funds market, show the impact of the increased government spending on the real interest rate in the economy. 2. How will the real interest rate change affect the growth rate of the United States economy? Explain.
Answer 1 points: One point is earned for a correctly labeled graph of the loanable funds market. One point is earned for showing a rightward shift of the demand curve and showing a higher real interest rate. (A leftward shift of the supply curve showing a higher interest rate is also accepted.) 2. 2 points: One point is earned for stating that the growth rate will fall. One point is earned for explaining that investment spending decreases and, as a result, capital formation will decrease.
FRQ Practice Q 3. Assume that the real interest rates in both Canada and India have been 5 percent. Now the real interest rate in India increases to 8 percent. a. Using a correctly labeled graph of the loanable funds market in Canada, show how the increase in the real interest rate in India affects the real interest rate in Canada.
Canadian Market for Loanable Funds r% S LF 1 S LF r 1 r D LF q 1 q Q LF S LF.: r% & Q LF
FRQ Practice Q answer key b) 2 points: One point is earned for a correctly labeled graph of the loanable funds market. One point is earned for showing a leftward shift of the supply curve and an increase in the interest rate.