Transcript The Loanable Funds theory

The Loanable Funds theory
We use the term “loanable funds
market” to describe the
arrangements and institutions by
which saving of households is
made available to borrowers.
1. Leakages must be recycled
if total spending is to
match full-employment
GDP.
2. According to the Classical
theory, the loanable funds
market acts as a conduit to
transfer spending power
(S) from households to
borrowing units (firms and
government units).
3. Saving (S) is the “source”
of loanable funds.
1. To have a more secure future, to start a
business, to finance a child’s education,
to satisfy miserliness, . . .
2. To earn interest.
We view interest as
the “reward for
saving” or the “reward
for postponing
gratification.”
Value of $1,000 in 3 years at
alternative interest rates
Interest rate Future value
4%
$1,127.27
5%
$1,161.47
6%
$1,196.68
7%
$1,232.93
8%
$1,270.24
9%
$1,308.65
10%
$1,348.18
11%
$1,388.88
12%
$1,430.77
The opportunity
cost of spending
now (measured in
lost future
spending) is
positively related to
the interest rate.
Supply of Funds
Interest rate
Saving = Supply
of Funds
5%
3%
0
1.5
1.75
Trillions of
Dollars
•To finance the acquisition of long-lived capital goods.
•The rate of interest is the cost of borrowing or the price of
loanable funds.
•The investment demand curve indicates the level of
investment spending at various interest rates.
•As the interest rate decreases, more investment projects
become attractive in the assessment of business decisionmakers—hence, the investment demand function is
downward-sloping with respect to the interest rate.
Interest rate
Demand for Funds
by Business
When the interest rate falls,
investment spending and the
business borrowing needed to
finance it rises.
A
5%
B
3%
0
Investment
Demand
1.0
1.5
Trillions of
Dollars
Public sector borrowing
•Let G denote public sector (or government)
spending for goods and services in a year
•T is net tax receipts in a year.
•If G is greater than T, the the public sector
has a budget deficit equal to G – T.
•If T is greater than G, then the public sector
has a surplus equal to T – G.
•If the public sector has a budget deficit, it
must borrow.
Federal Government Budget Surplus (Deficit) in billions , 1955-2000
300
www.economagic.com
200
100
0
-100
-200
-300
-400
55
60
65
70
75
80
85
90
95
00
Public Sector Borrowing in Classica
G = $2 trillion
T = $1.25 trillion
Therefore,
Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion
Government
Demand for Funds
5%
B
3%
A
0
0.75
Trillions of Dollars
Demand for Loanable Funds (in Trillions)
Interest Rate
5%
3%
[1]
[2]
[3] = [1] + [2]
Business Demand Government Demand Total Demand
1.0
1.5
0.75
0.75
1.75
2.25
Interest Rate
Total Demand for
Funds
5%
3%
0
1.75
2.25
Trillions of Dollars
Loanable Funds Market Equilibrium
Interest Rate
Total Supply of
Funds (Saving)
5%
E
Total Demand
for Funds
(Investment +
Deficit)
0
1.75
Trillions of Dollars
Why does the loanable funds theory
guarantee the validity of Say’s law?
S = IP + G - T
Quantity of Funds
Supplied
Quantity of Funds
Demanded
Now, rearrange the equation above by bringing T to
the left side:
S + T = IP + G
Leakages
Injections
So long as the loanable funds
market “clears,” leakages
(Saving) will be offset to
injections (investment and
government spending).
Income
Income
($7 Trillion)
($7 Trillion)
Consumption
($4 Trillion)
Households
Saving ($1.75 Trillion)
Net Taxes
($1.25 Trillion)
Government
Spending ($2
Trillion)
Government
Loanable Funds
Markets
Deficit
($0.75
Trillion
Resource
Markets
Goods
Markets
Investment
($1 Trillion)
Firm Revenues
($7 Trillion)
Firms
Factor Payments
($7 Trillion)
Changes in government spending, transfer
payments, and taxes designed to change total
spending in the economy and thereby influence
total output and employment.
The Classical view of Fiscal policy
Friends, we believe that fiscal
policy is unnecessary and
ineffective. The economy is doing
just fine without meddling by
Washington.
•Crowding out is the idea that an increase in one
component of spending will cause a decrease in other
spending components.
•An increase in G may cause a decrease in C, IP, or
both—that is, government spending may “crowd out”
private spending.
Crowding Out With an Initial Budget Deficit
Total Supply of
Funds (Saving)
Interest Rate
A
5%
•Increase in G = AH
B
7%
C
H
•Decrease in C = AC
•Decrease in IP = CH
D2 = IP +
G2 - T
D1 = IP +
G1 - T
0
1.75 2.05 2.25
Trillions of Dollars
Effects of a Reduction in the Government Surplus
S2 = Savings + T – G2
Interest Rate
S1 = Savings + T – G1
B
7%
H
5%
C
A
D = Investment
0
1.25 1.55
1.75
Trillions of Dollars