The Loanable Funds theory

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. me m su tt Ne a xe s 3. Saving (S) is the source

of loanable funds. co Saving 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). Co n 1. Leakages must be recycled

if total spending is to match full-employment GDP. or in pt io n Fa ct 1. To have a more secure future, to start a business, to finance a childs 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 decisionmakershence, 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. 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

Interest Rate 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 Says 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 Goods

Markets Resource 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 boththat is, government spending may crowd out private spending. Interest Rate

Crowding Out With an Initial Budget Deficit Total Supply of Funds (Saving) Increase in G = AH B 7% A 5% 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 7% 5%

B H C A D = Investment 0 1.25 1.55 1.75 Trillions of Dollars

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