Macroeconomics Chapter 9

Indirect finance

Banks collect savings from many sources and convert these to loans, as a channel for loanable funds Banks charge a higher rate of interest to borrowers than they pay to savers in order to make a profit.

Borrowing

Every dollar borrowed requires a dollar saved Lenders can't lend money they don't have Savings provides funds for lenders to lend Chain of borrowing: Savings → Borrowing → Investment → GDP The loanable funds market makes this process efficient

Future of loanable funds

Fall in the savings rate over past 30 years Increase in time preferences Leftward supply shift in loanable funds market Foreign savings in United States could shift supply back to the right Retirement of baby boomers Another reason to believe there will be a leftward shift in the supply of funds Result could be less investment and reduced GDP growth

Financial intermediaries

Firms that help channel funds from savers to borrowers Example: banks

Interest market

Good: Loanable funds Price: Interest Rate Sellers (Suppliers): Saveres Buyers (Demanders): Borroweres Equilibrium: Savings = Investment S: Savings D: Investment

Investor confidence

If a firm is optimistic, it will borrow more today Changes in capital productivity and investor confidence will shift the demand for loanable funds

Productivity of capital

If capital becomes more productive, the demand for loans will increase The returns on investment (at any interest rate) will be greater Example: Internet and computers

Midlife

If more people are in midlife and their prime earning years, savings is higher. If fewer people are in midlife, savings is lower. Income varies over the lifecycle, but people generally like to smooth consumption. Positive relationship

Factors that shift supply right

Income and Wealth + Time preferences - Consumption smoothing (midlife) + The quantity of loanable funds supplied is positively related to the interest rate.

Income and Wealth

Increases in income and wealth increase the supply of loanable funds. Decreases in income and wealth decrease the supply of loanable funds. Savings is more affordable when people have higher income and wealth. Positive relationship

Time Preferences

Increases in time preferences decrease the supply of loanable funds. Decreases in time preferences increase the supply of loanable funds. Lower time preferences indicate that people are more patient and more likely to save for the future. Negative relationship

Nominal interest rate

The interest rate before it is corrected for inflation real interest rate + inflation =

Real interest rate

The interest rate corrected for inflation Nominal interest rate-Inflation =

Loanable funds market

The market where savers supply funds for loans to borrowers. Includes such places as: stock exchanges investment banks mutual fund firms commercial banks Borrowers use funds for businesses Savers lend to businesses

Interest rate

The price of loanable funds Savers: the reward for saving Borrowers: the cost of borrowing Affected by supply and demand

Loanable funds "law of supply"

The quantity of savings rises when the interest rate increases

Borrowers

demanders of loanable funds include business firms and governments. Firms demand borrowed funds to finance large expenses, such as capital purchases or business expansions Borrow if Expected return on investment > Interest rate on loan

Fisher equation

estimates the relationship between nominal and real interest rates under inflation i=r+pi or real interest rate = nominal interest rate − inflation rate.

Direct finance

firms sell a security (like a bond or stock) directly to the public in exchange for funds. lender-savers purchase a financial security that yields future income and/or gives them ownership of a firm.

Savers

include households and foreign entities. Foreign entities include both the private citizens and governments that decide to save in the United States. Household savings in retirement accounts, stocks, bonds, and mutual funds are other big sources of loanable funds.

Shifts in the Demand (for Loanable Funds)

productivity of capital and investor confidence. An increase in either of these two factors would shift the demand curve for loanable funds rightward, also an increase in government borrowing is a factor. The quantity of loanable funds demanded is negatively related to the interest rate.

Bonds

used by large established firms when they need an infusion of money. Securities are issued and sold to the public. This is an example of direct finance. Funds generated are used for investment. formal IOU: A contract specifying who owes how much and a date for payment Info on this: Name of borrower, Repayment date (Maturity date), Amount due at repayment (Face value) Interest Rate= (Face value-price at inception)/price at inception Comapny must pay it back

Banks

Private firms that accept deposits and extend loans Banks are at the center of financial markets Banks help connect borrowers (demanders) with the savers (suppliers)