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MARKET FOR LOANABLE
FUNDS
• Suppliers are people who save money;
• Demanders are people who borrow
money;
• Interest Rate is the price of loanable
funds: the amount of money paid for
the use of a dollar for a year;
RESPONSE TO INCREASED INTEREST RATES
•
•
•
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PARTY NOW
Save less and spend more this year.
Since a higher interest rate means that each dollar saved
earns more interest, a person can save less and still have
the same amount of money to spend next year;
If interest rate changed from 4% to 10%, and person saved
$946 instead of $1,000, the person would still have $1,040,
and have $54 to party now.
PARTY LATER
• Save the same amount this year and spend more next
year;
• The higher interest rate means that a person who
continues to save the $1,000 this year will have more
money to spend next year;
• $1,100 instead of $1,040: $60 for next year’s party.
PARTY HEARTY LATER
• Save more this year and spend much more next year;
• A person who saves more than $1,000 will have much
more to spend next year;
• A person who saves $1,200 will have $1,320 instead of
$1,040.
THE SUPPLY CURVE FOR
LOANABLE FUNDS
• Shows the relationship between
interest rate and the total amount of
money saved -- and available to be
loaned;
• To find a point on the supply curve,
pick an interest rate and then add up
the amounts saved by each person in
the economy at that interest rate.
SUPPLY OF LOANABLE FUNDS
Interest Rate
Market Supply
(Percent)
Curve
Empirical studies
of saving behavior
h
6
suggest that on
average people save
e
4
more at higher
interest rates, so
b
supply curve is
2
positively sloped.
450 500
Loanable Funds per year ($ million)
SUPPLY OF LOANABLE FUNDS
• The higher the price (interest) the larger
the quantity supplied;
• What matters to potential savers is the net
benefit from saving money;
• If there were no taxes, the net benefit
would be determined exclusively by
interest rate;
• Because taxes decrease the net benefit
from savings, they decrease the amount of
money saved, decreasing the supply of
loanable funds.
THE MARKET DEMAND CURVE
Demand for loanable funds comes from
households, firms and government;
Households borrow money to purchase
expensive goods such as houses and cars;
Firms borrow money to purchase production
facilities such as buildings, machines and
equipment;
Governments borrow money to build facilities
such as highways, schools, dams and prisons;
The federal government borrows money for
the difference between tax revenue and
expenditures.
THE MARKET DEMAND CURVE
• The demand curve is negatively
sloped;
• The higher the interest rate, the
smaller the amount of funds
demanded.
EQUILIBRIUM IN THE MARKET FOR LOANABLE FUNDS
Interest Rate
Market Supply
(Percent)
Curve
6
d
h
Supply intersects demand at
e point e, so the equilibrium
interest rate is 4%.
4
2
b
c
Market Demand
Curve
450 500 720
Loanable Funds per year ($ million)
HOW DO CHANGES IN SUPPLY AND
DEMAND AFFECT MARKET INTEREST RATE
Increase In demand
Economic growth increases the demand for all goods in the
economy;
Firms respond to the increase in demand by expanding their
production facilities,
so the demand curve will shift to the right:
At each interest rate, firms will demand more funds.
Increase in Supply
If current workers decide to save more of their current
loanable funds for retirement, the supply curve for loanable
funds will shift right:
At each interest rate more money will be saved.
MARKET EFFECTS OF AN INCREASE IN DEMAND
Interest Rate
Market Supply
(Percent)
Curve
f
5
4
I
The increase in demand increases
both the price ( interest rate ) and
the quantity (quantity of loanable
funds).
New Demand Curve
Initial Demand Curve
500 590
Loanable Funds per year ($ million)
MARKET EFFECTS OF AN INCREASE IN SUPPLY
Interest Rate
Initial Supply
(Percent)
Curve
New Supply
Curve
4
3
e
f
The increase in supply
decreases the price ( interest
rate ) and increases the
quantity (quantity of loanable
funds).
Market Demand Curve
500 600
Loanable Funds per year ($ million)
OTHER CHANGES THAT AFFECT THE EQUILIBRIUM
INTEREST RATE
1. Government Spending
If government increases its spending without increasing taxes, it must
borrow money to finance the new spending. This deficit spending
increases the demand for loanable funds and increases the
equilibrium interest rate.
2. Investment subsidy
If the government provides a subsidy for spending on production
facilities (buildings, machines and equipment), firms will borrow
more money to spend on facilities, and the equilibrium interest rate
will increase.
3. Tax on interest income.
A tax on interest income decreases the benefit of saving:
For each dollar saved, the individual gets to keep only a part of the
interest income. The decrease in the benefit of saving will decrease
the supply of loanable funds, and increase the equilibrium interest
rate.
OTHER CHANGES THAT AFFECT THE
EQUILIBRIUM INTEREST RATE
4. Change in time preferences.
If people become more patient ( more
willing to delay consumption ), the supply
of savings will increase
and the equilibrium interest rate will
decrease.
SAVINGS ACCOUNT
• Can be opened in savings and loan, bank, or credit union;
• The federal government insures savings accounts for amounts up to
$100,000 per depositor.
BOND
• A promissory note issued by a corporation or government when it
borrows money;
• When buying a bond from a firm or government, you purchase the
right to receive a fixed amount of money (the face value of the bond)
at some future date and an annual interest payment;
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•
•
•
The purchase of a bond is risky because the issuer may default on the
bond;
Government bonds are less risky than corporate bonds because the
government is less likely to declare bankruptcy;
The risk associated with corporate bonds depends on the health of the firm:
The more profitable the firm, the lower the risk of default.
EQUILIBRIUM INTEREST RATES FOR
BANK SAVINGS ACCOUNTS AND CORPORATE BONDS
Interest
Rate ( % )
Supply for Interest
Rate ( % )
Savings
Accounts
b
6
s
5
Supply for
Corporate
Bonds
3
Demand
250
Funds in savings accounts
( $ millions )
Demand
100
Funds in Corporate Bonds
( $ millions )
CORPORATE STOCKS
• Corporation
A legal entity that is owned by people who purchase stock in the
corporation.
• Corporate Stock
When you buy a share ( 1 unit of ownership), you receive a certificate
reflecting ownership in the corporation and gain the right to receive a
fraction of the firm’s profit.
• Dividends
Most corporations pay part of their profits as dividends to their
stockholders;
they are typically paid four times a year (quarterly):
the higher the profit, the larger the dividend per share of stock;
Dividends are analogous to interest payments on savings accounts and
bonds;
POTENTIAL BENEFITS FROM BUYING STOCK
• Capital gains
If the market price of the stock increases, you can sell your stock for
more than you paid for it.
Risk of a stock
• Because a firm may turn out to be less profitable than expected, the
purchase of a share of stock is risky:
• dividends will be smaller than expected and the market price of the
stock may decrease;
• you may be forced to sell your stock for less than you paid for it.
COMPARING STOCK RATE-OF-RETURN TO INTEREST RATES OF BANK
ACCOUNTS AND BONDS
•
Because of the laws concerning bankruptcy, corporate stocks are more risky
than corporate bonds:
-- when a firm goes bankrupt, it sells its assets and pays its bondholders first;
-- stockholders are paid only if there is money left over after the firm pays its
bondholders.
• The greater risk associated with corporate stocks is reflected in higher rates
of return on corporate stocks.