Macro 7

increase in the demand for loanable funds.

An increase in expected profits increases the demand for funds today. The real interest rate rises. Saving and quantity of funds supplied increases.

The interest rate

on a financial asset is the interest received expressed as a percentage of the price of the asset.

Ricardo-Barro effect.

A budget deficit increases the demand for funds. Rational taxpayers increase saving, which increases the supply of funds. Increased private saving finances the deficit. Crowding-out is avoided.

effect of a government budget deficit

A government budget deficit increases the demand for funds. The real interest rate rises. Private saving increases. Investment decreases—is crowded out.

International Capital Mobility

Because lenders are free to seek the highest real interest rate and borrowers are free to seek the lowest real interest rate, the loanable funds market is a single, integrated, global market. Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest.

Changes in Demand and Supply

Financial markets are highly volatile in the short run but remarkably stable in the long run. Volatility comes from fluctuations in either the demand for loanable funds or the supply of loanable funds. These fluctuations bring fluctuations in the real interest rate and in the equilibrium quantity of funds lent and borrowed. They also bring fluctuations in asset prices.

Government in the Loanable Funds Market

Government enters the loanable funds market when it has a budget surplus or deficit. A government budget surplus increases the supply of funds. A government budget deficit increases the demand for funds.

increase in the supply of loanable funds

If one of the influences on saving plans changes and saving increases, the supply of funds increases. The real interest rate falls. Investment increases.

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied

The real interest rate

is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity coast of borrowing

The nominal interest rate

is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent.

The demand for loanable funds

is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. Business investment is the main item that makes up the demand for loanable funds.

The Supply of Loanable Funds Curve

is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. Saving is the main item that makes up the supply of loanable funds.

Physical capital

is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services.

Wealth

is the value of all the things that people own. Wealth also increases when the market value of assets rises—called capital gains—and decreases when the market value of assets falls—called capital losses

Funds come from three sources:

1. Household saving S 2. Government budget surplus (T - G) 3. Borrowing from the rest of the world (M - X)

The quantity of loanable funds supplied depends on

1. The real interest rate 2. Disposable income 3. Expected future income 4. Wealth 5. Default risk

The quantity of loanable funds demanded depends on

1. The real interest rate 2. Expected profit

Changes in the Supply of Loanable Funds

A change in disposable income, expected future income, wealth, or default risk changes the supply of loanable funds. An increase in disposable income, a decrease in expected future income, a decrease in wealth, or a fall in default risk increases saving and increases the supply of loanable funds.

International Borrowing and Lending

A country's loanable funds market connects with the global market through net exports. If a country's net exports are negative, the rest of the world supplies funds to that country and the quantity of loanable funds in that country is greater than national saving. If a country's net exports are positive, the country is a net supplier of funds to the rest of the world and the quantity of loanable funds in that country is less than national saving.

net worth

A financial institution's net worth is the total market value of what it has lent minus the market value of what it has borrowed. If net worth is positive, the institution is solvent and can remain in business. But if net worth is negative, the institution is insolvent and will go out of business.

effect of a government budget surplus

A government budget surplus increases the supply of funds. The real interest rate falls. Private saving decreases. Investment increases.

loanable funds curve

A rise in the real interest rate decreases the quantity of loanable funds demanded. A fall in the real interest rate increases the quantity of loanable funds demanded.

supply of loanable funds curve.

A rise in the real interest rate increases the quantity of loanable funds supplied. A fall in the real interest rate decreases the quantity of loanable funds supplied.

financial capital.

The funds that firms use to buy physical capital

The loanable funds market

The loanable funds market is global, not national. Lenders want to earn the highest possible real interest rate and they will seek it by looking around the world. Borrowers want to pay the lowest possible real interest rate and they will seek it by looking around the world. Financial capital is mobile: It moves to the best advantage of lenders and borrowers.

Finance and Money

The study of finance looks at how households and firms obtain and use financial resources and how they cope with the risks that arise in this activity. The study of money looks at how households and firms use it, how much of it they hold, how banks create and manage it, and how its quantity influences the economy.

Changes in the Demand for Loanable Funds

When the expected profit changes, the demand for loanable funds changes. Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment and the greater the demand for loanable funds.

A financial institution

is a firm that operates on both sides of the markets for financial capital. It is a borrower in one market and a lender in another.

Saving

is the amount of income that is not paid in taxes or spent on consumption goods and services. Saving increases wealth.

Net investment

is the change in the quantity of capital. Net investment = Gross investment Depreciation

Depreciation

is the decrease in the quantity of capital that results from wear and tear and obsolescence.

Gross investment

is the total amount spent on purchases of new capital and on replacing depreciated capital.