Loanable Funds in Economics

Loanable Funds Supply and Demand

• Household sector supplies the most loanable funds through savings.
• Businesses seek loanable funds for investments in both long-term and short-term assets, influenced by the number of projects planned.
• Successful businesses with excess cash flows can also supply loanable funds.
• Government demand for loanable funds arises when expenditures exceed tax revenues, typically issuing municipal bonds, Treasury, and agency securities.
• Government demand for funds is seen as interest-inelastic, meaning it does not heavily depend on interest rates.
• When governments run surpluses, they lend excess revenues to businesses and households, exemplified by DTI’s 1 billion pesos loan for MSMEs.

Expectations Theory

• This theory posits that interest rates are influenced by lenders' and borrowers' expectations of future market risks.
• Predicts short-term interest rates based on current long-term rates.
• Pure Expectations Theory: Suggests that the yield curve reflects expectations of future interest rates; when treasury bond demand increases, bond prices rise, consequently raising interest rates.

Risk-Free Rate and Government Securities

• The risk-free rate indicates zero default risk, typically aligned with government bond rates like Treasury Bills, which are fully backed by the government.
• In the Philippines, risk-free rates can be derived from the Philippine Dealing System (PDS) Group, which comprises four corporations focused on trading, settlement, training, and security services.

Nominal and Real Interest Rates

• Fisher’s theory explains that nominal interest compensates savers for lost purchasing power and for foregoing present consumption.
• The Fisher Effect describes how inflation impacts interest rates, indicating that savers need a premium over expected inflation for deferring consumption.
• Specific interest rate forecasts require precise data beyond what the yield curve provides.

Spot, Forward, and Swap Rates

• Spot Rate: The current interest rate available, used for immediate transactions, influenced by historical yields and market conditions.
• Forward Rate: Agreed upon today for a transaction in the future; it serves as a financial tool to manage risk over time.
• Swap Rate: Involves exchanging fixed interest rates for floating rates, used to mitigate the uncertainty of rate fluctuations in financial agreements.

Credit Ratings

• Credit ratings assess the risk associated with countries and corporations, influencing interest rates.
• A higher credit rating indicates lower default risk, essential for investors.
• Major credit rating agencies include:
  • Standard and Poor’s Corporation (S&P): Categorizes credit ratings from AAA (highest quality) to D (in default).
  • Moody’s Investors Service: Ranges from Aaa (minimal credit risk) to Caa (very high credit risk).

Rating Categories Defined

• S&P Ratings:
  • AAA: Extremely strong capacity to meet financial commitments.
  • AA: Very strong, likely to default due to high certainty.
  • C: Highly vulnerable to nonpayment.
  • D: Currently in default.
• Moody's Ratings:
  • Aaa: Highest quality, minimal credit risk.
  • Aa: High quality, very low credit risk.
  • B: Speculative, high credit risk.
  • Caa: Poor standing, very high credit risk.

This quiz explores the concepts surrounding loanable funds, focusing on the household sector as a primary supplier and the demand from businesses and government. Understand the dynamics of saving and investment for short-term and long-term assets. Test your knowledge on how these elements interact within the economy.