Loanable Funds Market: Supply and Demand

Loanable Funds Market

• Combines savers (supply) and borrowers (demand) to facilitate resource allocation.
• Savers provide savings, which become loans in the loanable funds market for borrowers.
• Interest rewards saving by compensating depositors for letting the bank use their money.
• Banks provide a service by connecting borrowers and savers, profiting from the difference between lending and deposit rates.
• Interest rate represents the cost of borrowing, influencing a firm's decision to expand.

Reasons Firms Borrow

• To facilitate growth by investing in resources.
• A well-functioning loanable funds market is necessary to maintain optimal GDP.
• GDP/output expansion requires investment, leading to borrowing, which consequently drives savings.

Factors Shifting Loanable Funds Supply

• Income and Wealth:
  • Higher income leads to increased saving.
  • Lower income reduces saving.
  • Increased income makes the U.S. economy less risky for foreign investors.
• Time Preferences:
  • More time availability results in lower savings.
  • Less time availability encourages higher savings.
• Consumption Smoothing: Adjusting saving and borrowing to maintain stable consumption levels over time.

Factors Affecting Loanable Funds Demand Curve

• Capital Productivity: Higher productivity increases demand for funds.
• Investor Confidence:
  • Uncertainty decreases demand for funds due to future concerns.

Factors Affecting Loanable Funds Supply Curve

• Time preferences.
• Wealth.
• Income.
• Consumption smoothing.
• Age distribution of population.

Production Process

• Borrowing enables investment, production, and eventual sale of output.

Interest Rates

• Represent the price of loanable funds, expressed as a percentage of the original loan amount.
• They reward saving and represent the cost of borrowing.
• From a supplier's perspective, the interest rate represents the opportunity cost of consumption.
• A higher rate incentivizes saving.
• From a demander's perspective, expected return is the anticipated rate of return based on potential outcomes.
• Borrowing occurs when the expected return on investment surpasses the cost of the loan/interest rate.

Real Interest Rate

• Measures the actual purchasing power derived from savings returns.

Nominal Interest Rate

• This is the interest rate reported by newspapers and used in financial transactions.

Interest Rate

• Price of loanable funds, expressed as an annual percentage of the amount borrowed.

Inflation Impact

• Real interest rate is adjusted for inflation.
• Represents the rate of return in terms of actual purchasing power.
• Nominal interest rate is the rate before inflation adjustment.
• Fisher Equation: Real rate = nominal rate - inflation rate.

Vocabulary

• Savings rate: Personal saving as a fraction of disposable income post-tax.
• Consumption Smoothing: Modifying borrowing and savings to stabilise consumption throughout one's life.
• Loanable Funds Market: Facilitates the exchange of funds between savers and borrowers.
• Expected Return: Predicted rate of return on capital investments considering all possible results.
• Dissaving: Using previously accumulated savings.
• Real Interest Rate: Compensation rate in terms of actual purchasing power by adjusting inflation.
• Nominal Interest Rate: Compensation agreed before adjusting for inflation
• Interest Rate: The percentage rate on original loan, paid from a borrower to a lender.
• Investor Confidence: Reflects anticipation for future economic activity

Financial Markets and Securities

• Financial intermediaries channel funds from savers to borrowers.
• Direct financing involves a tradeable contract giving the owner certain rights.
  • Bond is a type of security.

Bonds

• Tools issued to the public for borrowing and investment.
• Key components include borrower name, repayment (maturity) date, and amount due (par/face value).
• Prices are often quoted in interest rates, reflecting growth rate of original funds invested.
• Buyers/savers prefer higher interest rates, while sellers/borrowers prefer lower rates.
• Default risk refers to the risk that the borrower won't pay the face value upon maturity.
  • Higher risk results in lower bond prices.
• Bond ratings are evaluations/grades of default risk by agencies.
  • Agencies include Moody’s, Standard & Poor’s (S&P), and Fitch.
    • AAA ratings indicate stable firms.
    • BB and lower ratings indicate noninvestment grade (junk bonds).

Stocks

• Represent ownership shares in a firm.
• They enable owners to sell shares and move forward without debt.
• Secondary markets trade securities after their first sale.
  • These increase security demand.

Treasury Securities

• Bonds sold by the government to cover national debt.
  • They are considered less risky.
• These are sold through auctions to large firms.
  • Anyone can participate in the secondary market.
  • The auction price determines interest rate.

Home Mortgages

• These are loans used for purchasing homes.

Securitization

• Involves creating new securities by combining/bundling separate loan agreements.
  • Mortgage-backed security (MBS) bundles individual mortgages together.

The Aggregate Demand-Aggregate Supply Model in Macroeconomics

• Used to analyze long-run growth & development alongside short-run business cycle fluctuations.
  • Short-run is defined as five years or less.
• The AD-AS model mainly studies business cycles.

Aggregate Demand (AD)

• Represents the total demand for final Goods and Services.
  • Calculated as AD = C + I + G + NX (Consumption + Investment + Government Spending + Net Exports).

Inverse Relationship Between Price Level and Aggregate Demand (AD)

• Wealth Effect: An increase in overall prices reduces real wealth, decreasing consumption.
  • Subsequently, quantity of AD goes down.
• Interest Rate Effect: Rising price levels reduce saving abilities, decreasing loanable funds supply.
  • Interest rates rise, causing a reduction in the quantity of AD.
• International Trade Effect: Changes in U.S. Prices leads to changes in relative prices of goods.
  • Affecting Net Exports.

Aggregate Demand (AD) Curve Shifters

• Consumption, which is affected by: -Real Wealth. - Stock market fluctuations. - Real estate value changes.
  • Future expectations, which is affected by:
    • Changes in expected income.
    • Consumer confidence changes.
  • Taxes, which have an Inverse relationship.
• Investment:
  • Investment decisions.
  • Investor confidence which has a Linear relationship.
  • Interest rates, which have an Inverse relationship.
  • Money Supply, which has a Linear relationship.
• Government Spending which has a Linear relationship.
• Net Export Changes:
  • Income changes in foreign nations.
  • The value of the U.S. dollar, which is inverse.

Aggregate Supply

• Represents the overall supply of final Goods and Services.
• Shifts due to price levels impacting firms' supply decisions.
  • Long-run analysis considers the adjustment period for all prices.

The Long Run (LRAS) vs. Short Run (SRAS)

• Output Level is determined when an economy meets its natural rate of unemployment.
• LRAS is Vertical and is perfectly inelastic.
• LRAS Shifts when a nation's capacity to produce shifts, such as:
  • Increases/Decreases in resources.
  • Technological Advancements.
  • Modifications to Institutions.
• Short-run is an adjustment period for sticky prices.
  • Positive relationship between price level and As quantity due to:
    • Sticky input prices.
• SRAS shifts due to: - Input/resource prices, which have an Inverse relationship. - Supply shocks - Sudden events drastically altering firm production costs.
• LRAS shifts impact long-run and short-run.

Key Concepts in Macroeconomics

• Supply Shock: This is any sudden event altering production costs.
• Equilibrium in the AD-AS Model: Defined by Intersection between AD and AS.
  • Determines Output (Y), Price Level (P), & Unemployment (u).
  • LRAS Increases -> Higher Y, Lower u, & Stable P.
  • SRAS Shifts -> Changes in P and Y, & temporary u changes.
  • AD Shifts -> Short-run changes based on Y, P and u. - Long-run depends on LRAS adjustments.