Transcript real interest rate

29
Pump Primer:
• Draw a Loanable Funds Market
graph in Equilibrium.
Module 29
The Market
for Loanable Funds
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration
• Christians need to be mindful of certain
dangers and biblical cautions when it
comes to borrowing and lending. A debt
contract binds the borrower to the lender
(Prov. 22:7) Debt may be a fact of life for
everyone, but a Christian has to always
be wise and remain a good steward of
the money God has entrusted to them.
What you will learn
in this Module:
• 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
The Market for Loanable Funds
Closed economy: S = I
Add the public sector (government):
National savings = private savings + public
savings = I
Add the foreign sector:
National savings + capital inflow = I
The Market for Loanable Funds
It is through the financial markets by which the
funds of the savers are borrowed by investors.
Economists use the model of a market for
loanable funds to explain these interactions
and determine the equilibrium real interest rate.
The Market for Loanable Funds
A. The Equilibrium Interest Rate
Economists work with a simplified model in
which they assume that there is just one
market that brings together those who want to
lend money (savers) and those who want to
borrow (firms with investment spending
projects). This hypothetical market is known as
the loanable funds market.
The price that is determined in the loanable
funds market is the interest rate, denoted by r.
The Market for Loanable Funds
Interest rate on the vertical axis represents
the real interest rate, not the nominal.
Savers and borrowers care about the real
interest rate because that is what they earn
or pay after inflation.
Real interest rate = nominal interest rate –
expected inflation
If expected inflation = 0%, then: real rate =
nominal rate.
The Market for Loanable Funds
But, it’s also true that if expected
inflation is constant, any change in the
nominal rate will be reflected in an
identical change in the real rate.
This is why the graphs in the text are
labeled “nominal interest rate for a
given expected.
Vertical Axis as “real interest rate” or
“r”.
The Market for Loanable Funds
The Demand for Loanable Funds comes from
borrowers.
Demand is downward sloping for one very
intuitive reason.
Firms borrow to pay for capital investment
projects.
If the project has an expected rate of return that
exceeds the real interest rate, the investment will
be profitable, and the funds will be demanded.
The Market for Loanable Funds
Rate of return (%) = 100*(Revenue from project
– Cost of project)/(Cost of project)
As the real rate falls, more projects become
profitable, so the quantity of funds demanded will
increase.
The Market for Loanable Funds
The Supply of Loanable Funds comes
from savers.
Supply is upward sloping.
Savers can lend their money to
borrowers, but in doing so must forgo
consumption.
In order to compensate for the forgone
consumption, savers must receive
interest income and as the real interest
rate rises, the opportunity to earn more
income rises, so more dollars will be
saved.
The Market for Loanable Funds
As the real rate rises, the
quantity of funds supplied will
increase.
The price (interest rate) will adjust
to a shortage or a surplus in this
market in the same way as has
been done with other markets
Equilibrium in the Loanable
Funds Market
Here, the equilibrium interest rate is
r*%, at which Q* dollars are lent and
borrowed. Investment spending
projects with a rate of return of r*% or
more are funded; projects with a rate
of return of less than r*% are not.
Correspondingly, only lenders who
are willing to accept an interest rate
of r*% or less will have their offers to
lend funds accepted.
Shifts of the Demand for
Loanable Funds
The factors that can cause the
demand curve for loanable funds
to shift include the following:
Changes in perceived business
opportunities:
A change in beliefs about the rate
of return on investment spending
can increase or reduce the
amount of desired spending at
any given interest rate.
Shifts of the Demand for
Loanable Funds
If firms believe that the economy
is ripe with profitable investment
opportunities, the demand for
loanable funds will increase.
If firms believe the economy is
poised for a recession where
profitable investment
opportunities will be few and far
between, the demand will
decrease.
.
Shifts of the Demand for
Loanable Funds
Changes in the government’s
borrowing:
Governments that run budget
deficits are major sources of the
demand for loanable funds.
When the government runs a
budget deficit, the Treasury must
borrow funds and acquire more
debt. This increases the demand
for loanable funds in the market..
Shifts of the Demand for
Loanable Funds
If the government were to run a budget
surplus, less debt would be required
and the demand for loanable funds
would decrease.
The fact that the real interest rate
rises when the government increases
borrowing for debt provides us with a
preview of the negative impact of
debt. At higher interest rates, some
investment will be “crowded out” by
government demand for loanable
Shifts of the Supply of Loanable
Funds
Among the factors that can
cause the supply of loanable
funds to shift are the
following:
• Changes in private
savings behavior:
If households decide to
consume more and save
less, the supply of loanable
funds will shift to the left.
Shifts of the Supply of Loanable
Funds
• Changes in capital inflows:
For a variety of economic and political
reasons, a nation may receive more
capital inflow in a given year.
Shifts of the Supply of Loanable
Funds
If a nation is perceived to
have a stable government, a
strong economy and is a
good place to save money,
foreign money will flow into
that nation’s financial markets,
increasing the supply of
loanable funds.
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.
We have seen in previous modules that
unexpected inflation creates winners and losers,
particularly among borrowers and lenders.
Economists capture the effect of inflation on
borrowers and lenders by distinguishing between
the nominal interest rate and the real interest
rate, where the difference is as follows:
Inflation and Interest Rates
Real interest rate = Nominal interest rate —
Inflation rate.
For borrowers, the true cost of borrowing is the
real interest rate, not the nominal interest rate.
For lenders, the true payoff to lending is the real
interest rate, not the nominal interest rate.
Inflation and Interest Rates
Fisher Effect (after the American economist Irving
Fisher, who proposed it in 1930): the expected
real interest rate is unaffected by the change in
expected future inflation.
The Fisher effect says that an increase in
expected future inflation drives up nominal
interest rates, where each additional percentage
point of expected future inflation drives up the
nominal interest rate by 1 percentage point.
Inflation and Interest Rates
The central point is that both lenders and
borrowers base their decisions on the expected
real interest rate.
As long as the level of inflation is expected, it
does not affect the equilibrium quantity of loanable
funds or the expected real interest rate; all it
affects is the equilibrium nominal interest rate.
Inflation and Interest Rates
How does this work?
Step 1:
Expected inflation is 0% so, real =
nominal = 5% in equilibrium at
point A. Loanable funds are equal
to F1 dollars.
Inflation and Interest Rates
Step 2:
Borrowers and lenders all expect
inflation to be 5% into the future.
Nominal = 10%, real = 5%.
The demand curve for funds shifts
upward to D2: borrowers are now
willing to borrow as much at a
nominal interest rate of 10% as they
were previously willing to borrow at
5%.
Inflation and Interest Rates
That’s because with a 5% inflation rate, a 10% nominal
interest rate corresponds to a 5% real interest rate.
The supply curve of funds shifts upward to S2: lenders
require a nominal interest rate of 10% to persuade them
to lend as much as they would previously have lent at
5%.
The new equilibrium is at point B.
The result of an expected future inflation rate of 5% is
that the equilibrium nominal interest rate rises from 5% to
10%.
.
Inflation and Interest Rates
Reconciling the Two Interest Rate Models:
The short term interest rates are
determined at the intersection of money
demand and money supply.
In the loanable funds model, we see that
the interest rate matches the quantity of
loanable funds supplied by savers with
the quantity of loanable funds demanded
for investment spending.
Reconciling the Two Interest Rate Models:
The Interest Rate in the Short Run
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 then leads to a rise in both real
GDP and consumer spending, C.
The rise in real GDP leads to a rise in consumer
spending and also leads to a rise in savings: at each
stage of the multiplier process, part of the increase in
disposable income is saved. How much do savings
rise?
According to the savings–investment spending
identity, total savings in the economy is always
equal to investment spending.
Reconciling the Two Interest Rate Models
The Interest Rate in the Short Run :
Thus, a fall in the interest rate leads to higher
investment spending, and the resulting increase in
real GDP generates exactly enough additional
savings to match the rise in investment spending.
After a fall in the interest rate, the quantity of savings
supplied rises exactly enough to match the quantity
of savings demanded.
Reconciling the Two Interest Rate Models
The Interest Rate in the Long Run :
In the short run an increase in the money supply
leads to a fall in the interest rate, and a decrease in
the money supply leads to a rise in the interest rate.
In the long run, however, changes in the money
supply don’t affect the interest rate.
Why not?
Both the money market and loanable funds
markets are in equilibrium.
.
Reconciling the Two Interest Rate Models:
The Interest Rate in the Long Run
Reconciling the Two Interest Rate Models
The Interest Rate in the Long Run :
Now suppose the money supply rises from M 1
to M 2.
This initially reduces the interest rate to r2.
In the long run the aggregate price level will
rise by the same proportion as the increase in
the money supply (due to the neutrality of
money, a topic presented in detail in the next
section).
.
Reconciling the Two Interest Rate Models
The Interest Rate in the Long Run :
A rise in the aggregate price level increases money
demand in the same proportion. So in the long run the
money demand curve shifts out to MD2, and the
equilibrium interest rate rises back to its original level,
r1.
What about the loanable funds market?
An increase in the money supply leads to a short run rise in real GDP and that this shifts the supply
of loanable funds rightward from S1 to S2.
In the long run, real GDP falls back to its original
level as wages and other nominal prices rise.
.
Reconciling the Two Interest Rate Models
The Interest Rate in the Long Run :
As a result, the supply of loanable funds, S,
which initially shifted from S1 to S2, shifts back
to S1.
In the long run, then, changes in the money
supply do not affect the interest rate.
In the long run, the equilibrium interest rate
matches the supply and demand for loanable
funds that arise at potential output.
.