Market for Loanable Funds

 We will use a basic Supply and Demand Graph to
analyze this market
 The Market for Loanable Funds is NOT a real place.
 It is a composite representation of the financial
market/system where:
1. people/businesses/governments WITH money
supply it to others, and inreturn get an interest rate
they EARN for supplying that money.
2. People/businesses/government s WITHOUT money
borrow it from others, and in return get an interest rate
they PAY for demanding that money.
1

Real
Interest
Rate
Quantity of Loanable Funds
r*
QLF*
Demand for Loanable Funds*
(Consumers/Businesses)
Supply of Loanable Funds*
(Consumers/Businesses/Governments)
Market for Loanable Funds
2

Real
Interest
Rate
r*
QLF*
When Consumers/Businesses or
Governments have surplus
Funds they may want to
Place them in some type of
Savings and/or Investment
3

Real
Interest
Rate
r*
QLF*
This surplus savings is put
Into the financial system
As a SUPPLY of Loanable Funds
This surplus savings is put
Into the financial system
As a SUPPLY of Loanable Funds
4

Real
Interest
Rate
r
*
QLF*
What these savers/investors care about
Is the REAL INTEREST RATE they will
Earn on their money.
Remember the Real Interest Rate is what
You will earn AFTER inflation is factored
out
5

Real
Interest
Rate
r
*
QLF*
out
out
6
Real Interest Rate = Nominal Interest Rate - Inflation

Real
Interest
Rate
r*
QLF*
7
The Demand for Loanable Funds comes
From Consumers/Business/Governments
Who don’t have money, but want to borrow
It to finance their purchases

Real
Interest
Rate
r*
QLF*
8
What these BORROWERS care about
PAY on the money they BORROW.
out

Real
Interest
Rate
r*
QLF*
9
What these BORROWERS care about
PAY on the money they BORROW.
out
Real Interest Rate = Nominal Interest Rate - Inflation

Real
Interest
Rate
r*
QLF*
The REAL INTEREST RATE is a Long-Term interest
rate that both Borrowers AND savers are going
to consider when making decisions
10

Real
Interest
Rate
r*
QLF*
11
The Struggle Ensues….
Demanders for Loanable Funds desire a
LOWER Real Interest Rate because for :
1. Consumers it makes the purchases of houses,
Cars, Big Screen T.V.’s, etc LESS expensive

Real
Interest
Rate
r*
QLF*
12
1. Businesses it makes the purchases of Capital
Goods, expanding facilities, or building new facilities
LESS expensive

Real
Interest
Rate
r*
QLF*
13
1. Businesses it makes the purchases of Capital
Goods, expanding facilities, or building new facilities
LESS expensive

Real
Interest
Rate
r*
QLF*
14
The SUPPLIERS of Loanable Funds desire a
HIGHER Real Interest Rate because it makes the
Money they saved/invested GROW LARGER.

Real
Interest
Rate
r*
QLF*
15
Assume the Market for Loanable Funds is
In equilibrium at “r*”. At this Real Interest
Rate Demanders will demand QLF* and
Suppliers will supply QLF*. This is the
Market clearing “price”.

Real
Interest
Rate
r*
QLF*
16
ASSUMPTION
Assume the U.S. Government pursues an
Expansionary Fiscal Policy that requires it to
Deficit spend (spend MORE than they bring
In in Tax Revenue.

Real
Interest
Rate
r*
QLF*
17
In order to do this they will need to BORROW
Money (assuming they don’t just print it). The
U.S Government will enter the Market for
Loanable Funds as a DEMANDER (remember,
They don’t have money, they want it).

Real
Interest
Rate
r*
QLF*
18
This policy will INCREASE the
Demand for Loanable Funds
QLF₁
r₁
DLF (Consumers/Businesses₁ AND GOVERNMENT)

Real
Interest
Rate
r*
QLF*
19
QLF₁
r₁

Real
Interest
Rate
r*
QLF*
20
QLF₁
r₁
The REAL INTEREST RATE INCREASED
Because of Government Deficit Spending!!!

Real
Interest
Rate
r*
QLF*
21
QLF₁
r₁
The REAL INTEREST is HIGHER than
Before, so NOW for Consumers and/or
Businesses to BORROW will be MORE
Expensive due to the new Government policy

Real
Interest
Rate
r*
QLF*
22
QLF₁
r₁
This reduction in Consumer/Business borrowing because of Govt. deficit spending is
Called “THE CROWDING OUT EFFECT” of PRIVATE SPENDING. (C + I)

Real
Interest
Rate
r
*
QLF*
23
QLF₁
r₁
This is illustrated by the difference between the two equilibrium rates

Real
Interest
Rate
r*
QLF*
24
QLF₁
r₁
How much The Crowding Out Effect impacts
the economy is dependent upon how responsive
Consumers and Businesses are to changes in
The REAL INTERERST RATE

 If consumers and business are HIGHLY responsive to
increases in interest rates then the Crowding Out Effect
on Govt. spending will be “COMPLETE Crowding Out
Effect”
 If consumers and business are partially responsive to
increases interest rates then the Crowding Out Effect of
Govt. spending will be “Partial Crowding Out
Effect”
 If consumers and businesses are NOT responsive to
changes in interest rates then there will be No
Crowding Out Effect of Govt. spending.
25

Crowding Out Effect
and AD/AS
26
Price
Level
Real GDP
FE
GDP
SRAS
LRAS
AD*
AD/AS is indicating the
Economy is in a severe
Recession. Assume Govt.
Spending INCREASES
(through BORROWING)
And the economy returns
To Full-Employment RGDP
Spending INCREASES
(through BORROWING)
And the economy returns
To Full-Employment RGDP
RGDP*
PL*
PL₁
AD₁
This would suggest that C + I are NOT RESONSIVE to the INCREASE in the REAL INTEREST
RATE. Borrowing by C + I would not be effected---”NO CROWDING OUT EFFECT”
Actual RGDP = Potential RGDP

Crowding Out Effect
and AD/AS
27
Price
Level
Real GDP
FE
GDP
SRAS
LRAS
AD*
Spending INCREASES
(through BORROWING)
And the economy DOES NOT
Return to Full-Employment
RGDP.
Spending INCREASES
(through BORROWING)
And the economy DOES NOT
Return to Full-Employment
RGDP.
RGDP*
PL*PL₁
AD₁
This would suggest that C + I are PARTIALLY RESPONSIVE to the INCREASE in the REAL INTEREST
RATE. Borrowing by C + I would be NEGATIVELY effected---”PARTIAL CROWDING OUT EFFECT”
Actual RGDP < Potential RGDP
RGDP₁

Crowding Out Effect
and AD/AS
28
Price
Level
Real GDP
FE
GDP
SRAS
LRAS
AD*
Spending INCREASES
(through BORROWING)
And the economy STAYS THE
SAME. Any increase in Govt.
Spending is off-set COMPLETLEY
By the decreases borrowing
By consumers and businesses.
Spending INCREASES
(through BORROWING)
And the economy STAYS THE
SAME. Any increase in Govt.
Spending is off-set COMPLETLEY
By the decreases borrowing
By consumers and businesses.
RGDP*
PL*
PL₁
AD₁
This would suggest that C + I are 100% RESPONSIVE to the INCREASE in the REAL INTEREST
RATE. Borrowing by C + I would be 100% NEGATIVELY effected---”COMPLETE CROWDING OUT EFFECT”
Actual RGDP < Potential RGDP

 If Government INCREASES deficit spending and by doing so
INCREASES the REAL INTEREST RATE then it may have the
following effects:
 No Crowding out effect: Govt. spends and it DOES NOT effect
borrowing by C + I and the economy can return to Full-
Employment
 Partial Crowding Out: Govt. spends and it DOES effect
borrowing by C + I. C + I do not borrow AS MUCH thus
potentialLY causing the economy to NOT RETURN TO FULL
EMPLOYMENT.
 Complete Crowding Out: Government Spends and it has the
effect of causing C + I to NOT borrow and the economy
virtually stays the same: NO INCREASE RGDP
29

 If interest rates increase due to Government borrowing
AND if it “crowds out” PRIVATE INVESTMENT in the
business sector the following could happen:
 Capital projects (expanding facilities, building new facilities)
will become less profitable.
 Business will not borrow to replace capital equipment.
 Short term Aggregate Demand will be adversely affected.
 Long Run Aggregate Supply (PPF) will be adversely
affected because the CAPITAL STOCK of the
economy will become obsolete and/or depleted.
Essentially Capital Stock will DECREASE.
30

Market for Loanable Funds

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