Chapter 9: Savings, Interest Rates, and the Market for Loanable Funds

Every dollar __________ requires a dollar __________

borrowed, saved - lenders can't lend money they don't have - savings provides funds for lenders to lend

What role do banks play in financial markets? A. Banks affect the money supply by minting new currencies B. Banks set the interest rate C. Banks sell stocks to the government D. banks act as financial intermediaries between borrowers and savers

financial markets are comprised of financial securities and financial intermediaries. banks are the financial intermediaries

Stocks

financial securities that represent partial ownership of a firm

Bonds

financial securities that represent promises to repay a fixed amount of funds

Who are the borrowers in the loanable funds market?

firms and government

financial intermediaries

firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers

Financial markets

markets where financial securities, such as stocks and bonds, are bought and sold

What is the fisher equation?

real interest rate = nominal interest rate - inflation rate nominal interest rate = real interest rate + inflation rate

What does the fisher equation do?

relates inflation to the real and nominal interest rate

How would consumption tax affect saving, investment, the interest rate, and economic growth?

review slides 45-49

What is the chain of borrowing?

savings to borrowing to investment to GDP GDP increases because I increases the loanable funds market makes this process efficient

What is included in the loanable funds market?

stock exchanges, investment banks, mutual fund firms, commercial banks think banks, bonds, stocks. those are the big three

What does the process of economic growth depend on?

the ability of firms to expand their operations, buy additional equipment, train workers, and adopt new technologies

Nominal interest rate

the interest rate before it is corrected for inflation the nominal interest rate will always be higher than the real interest rate (exception was the period of deflation at the end of the Great recession, when the real interest rate was actually above the nominal interest rate)

Real interest rate

the interest rate corrected for the effects of inflation this is more important for both savers and borrowers

What is the financial system?

the system of financial markets (such as stock or bonds market) and financial intermediaries (banks) through which firms acquire funds from households.

Time preferences: direction of effect

**lower time preferences indicate that people are more patient and more likely to save for the future** INCREASE in time preferences DECREASE the supply of loanable funds DECREASE in time preferences INCREASE the supply of loanable funds

The loanable funds market, supply and demand graph

- Good: loanable funds - Price: Interest Rate - Suppliers: Savers - Demanders: Borrowers

What happens if there is an increase in the demand for loanable funds?

- an increase in the demand for loanable funds increases the equilibrium interest rate and it increases the equilibrium quantity of loanable funds - as a result, saving and investment both increase

What causes a shift in the supply of loanable funds?

- anything that would make saving more or less attractive. primarily... - changes in income or wealth - change in time preferences - consumption smoothing

How do borrowers and savers participate in the loanable funds market?

- borrowers use funds for businesses - savers lend to businesses savers dump savings into the loanable funds market. borrowers take out loans from the loanable funds market.

Demand for loanable funds

- comes from firms and business that take out loans for the purpose of investment - interest rate is the cost of borrowing

Supply of loanable funds

- comes from people saving money - interest rate is a reward for savings

What causes movement along the supply curve for loanable funds?

- first of all, a movement along the supply curve for loanable funds indicates an increase or decrease in quantity supplied of savings - caused by a change in interest rate, which is the reward for saving - an increase in the interest rate will increase the supply for loanable funds - a decrease in the interest rate will decrease the supply for loanable funds

What are interest rates like on the borrowing side?

- for borrowers, the interest rate is the cost of borrowing. - a firm should borrow funds IF expected return on investment > interest rate on loan (this is a cost-benefit analysis to see if its worth it to take out a loan)

Investor Confidence

- if a firm is optimistic, it will borrow more today - an increase in investor confidence will increase the demand for loanable funds

How does Productivity of Capital shift the demand for LF?

- if capital becomes more productive, the demand for loans will increase - the returns on investment (at any interest rate) will be greater in the capital is more productive - ex: internet and computers

Equilibrium in the market for loanable funds

- in equilibrium, Savings = Investment - supply of loanable funds is people's savings - demand for loanable funds is firms wanting to borrow for investment purposes - this goes back to the relationship between saving and borrowing. every dollar borrowed requires a dollar saved

How does income and wealth affect the supply for LF?

- increase in income generally increase savings - high - income people (and countries) save more than low-income people (and countries) at the same interest rate - when people save, they also want to save where the interest rate is highest (this is why many foreign investors have invested savings in the US, where the interest rate is higher)

What happens when there is a decline in investor confidence?

- investor confidence tends to decline when the economy slows - firms expect reduces sales, and investors expect lower returns on their investment - model predicts that this will result in a lower level of investment and a lower interest rate - investment fell during both US recessions between 2000 and 2012

Time preferences

- people generally prefer goods sooner rather than later, and funds are no different - would you rather have $50 now or later? I think you'd choose now - Loans are paid back at a later date to allow for someone's time preference (bc they want that money now, even if they can't quite pay for all of it right now) - to compensate, you must pay someone to borrow from them, or they must pay you when you loan them funds - the longer the loan period, the higher the payment

Direct Finance

- savers buy financial securities from borrowers. - firms sell a security (stock or bond) directly to the public in exchange for funds - security pays future income and/or gives part ownership of the firm

Indirect finance

- savers deposit funds into banks, and banks lend these to borrowers. - banks pay lower interest rates to savers than they charge borrowers. this is how they make profit

Higher interest rates yield greater future returns?

- the higher the interest rate, the more money you'll rack up after one year. - let's say you deposit $500 into your savings. - if interest rate is 4%, in a year you'll have $520 - 5%, $525 - 6%, $530 - 10 %, $550

equilibrium in the loanable funds market determines what?

- the level of interest rate in an economy (that is attractive to both the suppliers(savers) and the borrowers(investors))

What is an interest rate?

- the price of loanable funds - an interest rate is a reward for savers and a cost to borrowers - like other prices, it rises and falls - it is affected by the supply and demand

How does interest rate on savings work?

- the price you receive on your saving is the interest rate. it is your reward for saving. EXAMPLE: interest rate is 3%. - $500 * .03 = $15 - saving $500 will pay $15 for the year

Loanable funds "law of supply"

- the quantity of savings rises when the interest rate rises - you'll save more if you know you can get more money for it

How will the retirement of baby boomers impact the supply of loanable funds?

- there will be a leftward shift because they will start entering the "dissaving" portion of the consumption smoothing graph - a result could be less investment and reduced GDP growth - downward pressure on savings

What is the effect of a budget deficit on the market for loanable funds?

- when the government begins running a budget deficit, the supply of loanable funds shifts to the left (bc there are less taxes) - the equilibrium interest rate increases, and the equilibrium quantity of loanable funds decreases - as a result, saving and investment both decline.

What is true about equilibrium in the market for loanable funds? A. Savings = Investment B. Interest rate = inflation C. Investment = interest rate D. Savings = GDP

A. Savings = Investment because every dollar borrowed requires a dollar saved

Where does the supply of funds in the loanable funds market come from? A. banks printing money B. firms borrowing money for investment C. Government tax revenues from citizens D. Consumers saving their money at banks

D. Consumers saving their money at banks

In the basic consumption-smoothing model, when are consumers dissaving? A. During their prime years B. in their 20s and 30s C. very early in life D. Late in life

D. Late in life

The interest rate can be thought of as... A. the rate at which banks loan funds B. the return on capital investment C. The real rate of inflation D. The price of money

D. The price of money

Why is the loanable funds market important?

Firms need to borrow before their production begins. They build capital goods and hire workers today in order to repay loans and pay workers in the future

Income and wealth: direction of effect

INCREASE in income and wealth INCREASE the supply of loanable funds DECREASE in income and wealth DECREASE the supply of loanable funds

How will an increase in time preferences affect the loanable funds market? there will be... A. An increase in the supply of loanable funds B. A decrease in the supply of loanable funds C. An increase in the demand of loanable funds D. A decrease in the demand of loanable funds

If there is an increase in time preferences, people are less patient and less likely to save for their future (they'd rather just spend the money now) B. A decrease in the supply of loanable funds

Time preference example: Decision to attend college

Option 1: get a job, earn money immediately, consume now Option 2: go to college, forgo current income and consumption for higher consumption and income in the future

What do you do when you save money?

You supply funds which can be lent out

What causes movement along the demand curve for LF?

a change in the interest rate, which is the price of borrowing a decrease in the interest rate will increase demand for LF. an increase in the interest rate will decrease the demand for LF.

whats a financial security?

a document that states the terms under which funds pass from the buyer of the security to the seller stocks and bonds

What causes shifts in the demand for LF?

anything that would make borrowing more or less attractive. primarily... - changes in the productivity of capital - changes in investor confidence

Who are the savers in the loanable funds market?

households and foreign entities

Consumption smoothing: direction of effect

if MORE people are in midlife and their prime earning years, savings is HIGHER if FEWER people are in midlife, savings is LOWER

Summary: Factors that impact the supply of loanable funds?

income and wealth, time preferences, consumption smoothing

Consumption smoothing

income changes over the course of the typical lifetime - young students and elderly retirees don't work, but most people do earn income in between those years however, consumption doesn't change much throughout your years - young people and retirees still consume goods and services - these goods and services are paid for by borrowing or using savings - we don't experience large changes in consumption with changes in income

Which is an example of indirect finance? A. Ashley closes her account at green bank. B. Ethan deposits money in blue bank, and jenna take out a loan from blue bank C. Lindsay buys a bond from a large pharmaceutical company D. Derek buys 100 shares of stock at the initial public offering of a company

indirect finance is when savers save in the bank and then that money is lent out. C and D are examples of direct finance. B. Ethan deposits money in blue bank, and jenna take out a loan from blue bank