Macro Chapter 31

Examples of what households do with saving:

-Buy corporate bonds or stocks; -Purchase a certificate of deposit at the bank; -Buy shares of a mutual fund; and -Let accumulate in saving or checking accounts.

The demand for loanable funds comes from investment:

Firms borrow funds to pay for new equipment, to build new factories, etc.. Households borrow funds to purchase new houses.

Note the difference between supply and the quantity supplied of loanable funds:

The supply of loanable funds shows the relationship between the real interest rate and the amount of saving. The quantity supplied of loanable funds is the quantity of saving supplied at a particular real interest rate.

Like many other markets, financial markets are governed by the forces of supply and demand. Financial markets help allocate the economy's scarce resources to their most efficient uses. A well-functioning market matches....

buyers and sellers, who can both gain from trade. Buyers want to spend funds on something valuable now. Sellers let others borrow funds for a price.

Securities are broadly categorized into debt securities such as bonds, and equity securities such as stocks. A bond is a....

certificate of indebtedness, or a debt instrument. The issuer or supplier of a bond is a borrower while the buyer or demander of a bond is a saver/lender.

Financial institutions in which savers can indirectly provide funds to borrowers through an intermediary are called financial intermediaries. The term "intermediary" means middleman, reflecting the role of these institutions in standing between the savers and the borrowers. Examples of financial intermediaries include.....

commercial banks, pension funds, insurance companies, credit unions and mutual funds.

The demand curve for loanable funds is downward sloping because a fall in the real interest rate reduces the.....

cost of borrowing, which increases the quantity of loanable funds demanded.

If there weren't banks, you could borrow from your family and/or friends. But if you went bankrupt, they would have no way of getting their funds back. However, banks can survive even if a few borrowers default on their loans, because most borrowers do repay. This means that no individual saver has to bear the full burden of a default. In this way, banks allow savers and borrowers to...

diversify risk.

Saving is the source of the supply of loanable funds. Therefore, the supply of loanable funds is....

equivalent to the supply of saving in the nation. The supply of loanable funds curve is upward sloping because an increase in the real interest rate makes saving more attractive, thereby increasing the quantity of loanable funds supplied.

Do not confuse commercial banks with investment banks. Unlike commercial banks and credit unions, investment banks do not take deposits. An investment bank is a....

financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities; and in assisting with mergers and acquisitions. Examples of investment banks include Goldman Sachs and JP Morgan.

The term "loanable funds" means:

funds available for borrowing - the amount that investors have chosen to borrow to fund new investment. Funds available for lending -the income that people have chosen to save rather than consume.

The supply of loanable funds comes from saving. Private saving -- households with extra income can loan it out and earn interest. Public saving, if positive, adds to.....

national saving and the supply of loanable funds. If negative, public saving reduces national saving and the supply of loanable funds.

In some financial markets, savers can directly provide funds to borrowers. The two most important such financial markets are the bond market and the stock market. Stocks and bonds are also called securities.A security is a....

negotiable financial instrument representing financial value.

mutual funds are institutions that....

sell shares to the public and use the proceeds to buy portfolios of stocks and bonds. One big advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings.

Investment

spending on productive inputs. Productive inputs include factories, machinery, and inventories.

Savings

the portion of income that is not immediately spent on consumption of goods and services. When people put money into stocks or a 401(k) retirement, many people see this as "investment." But economists see this as savings.

The loanable funds market is a supply-demand model of the financial system. The loanable funds model helps us understand how the financial system coordinates saving and investment and how government policies and other factors affect saving, investment and the interest rate. The loanable funds market is a....

theoretical construct to describe the aggregate markets through funds flow from savers (lenders) to borrowers.

Assumptions of the loanable funds model:

-There is only one financial market called the loanable funds market. -All savers deposit their saving in this market. -All borrowers take out loans from this market. -Borrowers take out loans to finance investment. -There is one interest rate, which is both the return to saving and the cost of borrowing ("price" of the loan). -Since borrowers care about the true cost of borrowing and lenders care about the true rate of return, the interest rate in the model is the real interest rate.

The financial system is the group of institutions that move funds from savers (lenders) to borrowers. Essentially, in financial institutions, people trade future claims on funds or goods. These "claims" can take different forms such as:

-When you get a loan, the bank gives you money now in return for repayment in the future. -Buying a company stock today gives you a right to a share of profits in the future. -When you buy a bond, you lend a borrower money now in return for repayment in the future (like a loan). -When you purchase insurance, you pay premiums now in return for the right to submit a claim for compensation in the future.

Financial intermediaries such as commercial banks serve many useful functions:

-act as an intermediary between savers and borrowers. -make cash more readily accessible when and where you want it. -let people enjoy the benefits of liquidity. -allow savers and borrowers to diversify risk.