Transcript Loanable Funds

Loanable Fund and Exchange
Markets
IMBA Macroeconomics III
Lecturer: Jack Wu
Recall GDP formula

Recall that GDP is both total income in
an economy and total expenditure on
the economy’s output of goods and
services:
Y = C + I + G + NX
Important identities



Assume a closed economy – one that does not
engage in international trade:
Y=C+I+G
Now, subtract C and G from both sides of the
equation:
Y – C – G =I
The left side of the equation is the total income in
the economy after paying for consumption and
government purchases and is called national saving,
or just saving (S).
Important identities: continued


Substituting S for Y - C - G, the
equation can be written as:
S=I
National saving, or saving, is equal to:
S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
Meaning of Saving


National Saving
 National saving is the total income in the
economy that remains after paying for
consumption and government purchases.
Private Saving
 Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
Private saving = (Y – T – C)
Meaning of Saving: Continued

Public Saving
 Public saving is the amount of tax
revenue that the government has left
after paying for its spending.
Public saving = (T – G)
Budget

Surplus and Deficit



If T > G, the government runs a budget
surplus because it receives more money
than it spends.
The surplus of T - G represents public
saving.
If G > T, the government runs a budget
deficit because it spends more money
than it receives in tax revenue.
Saving = Investment?

For the economy as a whole, saving
must be equal to investment.
S=I
Market for Loanable Funds



Financial markets coordinate the economy’s
saving and investment in the market for
loanable funds.
The market for loanable funds is the market
in which those who want to save supply
funds and those who want to borrow to
invest demand funds.
Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
Supply and Demand for
Loanable Funds


The supply of loanable funds comes
from people who have extra income
they want to save and lend out.
The demand for loanable funds comes
from households and firms that wish to
borrow to make investments.
Price of the Loan



The interest rate is the price of the
loan.
It represents the amount that
borrowers pay for loans and the
amount that lenders receive on their
saving.
The interest rate in the market for
loanable funds is the real interest rate.
Equilibrium

Financial markets work much like other
markets in the economy.

The equilibrium of the supply and
demand for loanable funds determines
the real interest rate.
Interest
Rate
Supply
5%
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
Copyright©2004 South-Western
Government Policies

Government Policies That Affect
Saving and Investment



Taxes and saving
Taxes and investment
Government budget deficits
Saving Incentives: Tax Cut


Taxes on interest income substantially
reduce the future payoff from current saving
and, as a result, reduce the incentive to
save.
A tax decrease increases the incentive for
households to save at any given interest
rate.



The supply of loanable funds curve shifts to the
right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds
increases.
Interest
Rate
Supply, S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
Demand
0
$1,200
$1,600
Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Investment Incentives:
Investment Tax Credit

An investment tax credit increases the
incentive to borrow.



Increases the demand for loanable funds.
Shifts the demand curve to the right.
Results in a higher interest rate and a
greater quantity saved.
Interest
Rate
Supply
1. An investment
tax credit
increases the
demand for
loanable funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
0
D2
Demand, D1
$1,200
$1,400
Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Government Budget Deficit


When the government spends more
than it receives in tax revenues, the
short fall is called the budget deficit.
The accumulation of past budget
deficits is called the government debt.
Crowding Out


Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
This fall in investment is referred to as
crowding out.

The deficit borrowing crowds out private
borrowers who are trying to finance
investments.
Budget Deficit

A budget deficit decreases the supply
of loanable funds.



Shifts the supply curve to the left.
Increases the equilibrium interest rate.
Reduces the equilibrium quantity of
loanable funds.
Interest
Rate
S2
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
Demand
0
$800
$1,200
Loanable Funds
(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Net Capital Outflow

Net capital outflow refers to the
purchase of foreign assets by
domestic residents minus the
purchase of domestic assets by
foreigners.

A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in
the Ford Motor corporation.
Variables influencing Net
Capital Outflow

Variables that Influence Net Capital
Outflow




The real interest rates being paid on
foreign assets.
The real interest rates being paid on
domestic assets.
The perceived economic and political
risks of holding assets abroad.
The government policies that affect
foreign ownership of domestic assets.
NX=NCO


Net exports (NX) and net capital
outflow (NCO) are closely linked.
For an economy as a whole, NX and
NCO must balance each other so that:
NCO = NX

This holds true because every
transaction that affects one side must
also affect the other side by the same
amount.
S=I + NCO

National saving is the income of the
nation that is left after paying for
current consumption and government
purchases:
S=Y - C - G = I + NX
S=I + NCO
National Saving = Investment + Net
Capital Outflow
Nominal Exchange Rate


The nominal exchange rate is the rate
at which a person can trade the
currency of one country for the
currency of another.
The nominal exchange rate is
expressed in two ways:


In units of foreign currency per one U.S.
dollar.
And in units of U.S. dollars per one unit of
the foreign currency.
Real Exchange Rate


The real exchange rate is the rate at
which a person can trade the goods
and services of one country for the
goods and services of another.
The real exchange rate compares the
prices of domestic goods and foreign
goods in the domestic economy.

If a case of German beer is twice as
expensive as American beer, the real
exchange rate is 1/2 case of German
beer per case of American beer.
Formula
Nominal exchange rate  Domestic price
Real exchange rate=
Foreign price
The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning
Foreign-Currency Exchange
Market



The two sides of the foreign-currency
exchange market are represented by
NCO and NX.
NCO represents the imbalance
between the purchases and sales of
capital assets.
NX represents the imbalance between
exports and imports of goods and
services
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning
Equilibrium in Open Economy


In the market for loanable funds,
supply comes from national saving and
demand comes from domestic
investment and net capital outflow.
In the market for foreign-currency
exchange, supply comes from net
capital outflow and demand comes
from net exports.
Equilibrium in Open Economy

Net capital outflow links the loanable
funds market and the foreign-currency
exchange market.

The key determinant of net capital
outflow is the real interest rate.
How Net Capital Outflow Depends on the
Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
Copyright©2003 Southwestern/Thomson Learning
Equilibrium in Open Economy


Prices in the loanable funds market
and the foreign-currency exchange
market adjust simultaneously to
balance supply and demand in these
two markets.
As they do, they determine the
macroeconomic variables of national
saving, domestic investment, net
foreign investment, and net exports.
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
Demand
Net capital
outflow, NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
Supply
E
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Policies

The magnitude and variation in
important macroeconomic variables
depend on the following:



Government budget deficits
Trade policies
Political and economic stability
Government Budget Deficits

In an open economy, government
budget deficits . . .




reduce the supply of loanable funds,
drive up the interest rate,
crowd out domestic investment,
cause net foreign investment to fall.
The Effects of Government Budget Deficit
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
r
2. . . . which
increases
the real
interest
rate . . .
S
1. A budget deficit reduces
(b) Net Capital Outflow
the supply of loanable funds . . .
Real
Interest
Rate
S
B
r2
A
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
5. . . . which
causes the
real exchange
rate to
appreciate.
E1
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Trade Policy

A trade policy is a government policy
that directly influences the quantity of
goods and services that a country
imports or exports.


Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a
good produced abroad and sold
domestically.
The Effects of an Import Quota
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
2. . . . and
causes the
real exchange
rate to
appreciate.
Supply
1. An import
quota increases
the demand for
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Capital Flight




Capital flight is a large and sudden
reduction in the demand for assets
located in a country.
Capital flight has its largest impact on
the country from which the capital is
fleeing, but it also affects other
countries.
If investors become concerned about
the safety of their investments, capital
can quickly leave an economy.
Interest rates increase and the
The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
(b) Mexican Net Capital Outflow
Real
Interest
Rate
Supply
r2
r2
r1
r1
1. An increase
in net capital
outflow. . .
D2
3. . . . which
increases
the interest
rate.
D1
2. . . . increases the demand
for loanable funds . . .
NCO1
Quantity of
Loanable Funds
NCO2
Net Capital
Outflow
Real
Exchange
Rate
E
5. . . . which
causes the
peso to
depreciate.
S
S2
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . .
E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning