RMIT Classification: Trusted

Chapter 22
Savings, Interest Rates,
and the Market for
Loanable Funds

Copyright © 2021 by W. W. Norton & Company, Inc. 1

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Big Questions

1. What is the loanable funds market?

2. What factors shift the supply of loanable funds?

3. What factors shift the demand for loanable funds?

4. How do we apply the loanable funds market model?

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Savings, Interest Rates, and the

Market for Loanable Funds
Market Supply Demand

• Interest rates • Income and wealth • Productivity of capital

• Equilibrium • Time preferences • Investor confidence

• Consumption • Government

smoothing borrowing

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Loanable Funds Market (1/4)

Loanable Funds Market: The market where ________ supply funds

for loans to ____________.

Includes such places as:

•
•
•

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Loanable Funds Market (2/4)

Why do firms need to borrow?

• Most businesses cannot ______ ________ and other investment

purchases with cash alone.

• Without the loanable funds market, much ______________ would be

impossible and production and GDP would falter.

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Loanable Funds Market (3/4)

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Loanable Funds Market (3/3)

Where do firms get their funds from?

Every dollar ____________ requires a dollar ________.

• Lenders can’t lend money they don’t have.
• Savings provides funds for lenders to lend.

Chain of borrowing:

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Interest Rates (1/2)

What are interest rates?

Determined by market supply and demand.

Can be viewed as:

• the reward for __________.

• the price of ____________.

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Interest Rates (2/2)

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Interest Rates from the Supply Side

(1/3)

From the saver’s perspective:

When you save money, you are supplying funds.

The ________ you receive in return is the interest

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Interest Rates from the Supply Side

(2/3)

Example:

Interest rate = _____ per year.

Saving ______ will pay _____ for the year.

What is the “law of supply” for loanable funds?

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Interest Rates from the Supply Side

(3/3)

_________ interest rates yield _________ future returns.

This table represents the future value of $500 in savings at different

interest rates. Interest Value After

Rate 1 Year
4%
5%
6%
10%

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Practice What You Know—1

Where does the supply of funds in the loanable funds market come

from?

A. Banks printing money.

B. Firms borrowing money for investment.

C. Government tax revenues from citizens.

D. Consumers saving their money at banks .

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Interest Rates from the Demand Side

From the borrower’s perspective:

• Interest rate is the ______ of ____________.

When should a firm borrow?

• Borrow funds if ___________ _______ ___ _____________

is greater than the interest rate on the loan.

When will profit-maximizing firms borrow funds?

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Practice What You Know—2

The interest rate can be thought of as:

A. the rate at which banks loan funds.

B. the return on a capital investment.

C. the real rate of inflation.

D. the price of money.

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Real and Nominal Interest Rates

Real interest rate:

Nominal interest rate:

What is the Fisher Equation?

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Real and Nominal Interest Rates,

1970–2018
What happens when inflation is high?

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Loanable Funds Market Summary

• Supply of Loanable Funds • Demand of Loanable Funds

•
• Comes from people saving
• Comes from people wanting
money
to borrow money
• Interest rate is ___

________ _____ ________ • Interest rate is the _____

___ ____________
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Supply of Loanable Funds

Movement along the supply curve for loanable funds is caused by:

Shift in the supply of loanable funds is caused by:

• changes in _______________________

• changes in ___________________

• consumption ______________.

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Changes in Income and Wealth

___________ in either income or wealth generally produce

___________ in savings.

What happens as the world gets richer?

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Time Preferences (1/2)

What are time preferences?

Two general rules of preferences:

1. People prefer ______ to ______.

2. People prefer ______ to ______.

• If you make someone wait until later, you must compensate by

giving them more!

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Time Preferences (2/2)

Application: Decision to attend college.

Option 1: Get a job.

Option 2: Go to college.

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Practice What You Know—3

How will an increase in time preferences affect the loanable funds

market? There will be a(n):

A. increase in the supply of loanable funds.

B. decrease in the supply of loanable funds.

C. increase in the demand of loanable funds.

D. decrease in the demand of loanable funds.

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Consumption Smoothing (1/2)

What is consumption smoothing?

Over their lifetime, people will ________, _______ and then

__________.

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Consumption Smoothing (2/2)

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Practice What You Know—4

In the basic consumption-smoothing model, when are consumers

dissaving?

A. During prime earning years

B. In their 20s and 30s

C. Very early in life

D. Late in life

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Shifts in the Supply of Loanable Funds

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Supply of Loanable Funds Summary

Factor Direction of Effect Explanation

Income and wealth As income and wealth Saving is _______

__________, so does affordable when people
supply. have ________ income
and wealth.
Time preferences As time preferences _________ time
____________, supply preferences indicate that
____________. people are ________
patient and _______ likely
to save for the future.
Consumption smoothing As _______ people are in Income varies over the life
midlife and prime earning cycle, but people generally
years, supply like to ________
___________. ______________.

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Savings Rate in the United States,

1970–2018
The savings rate _____ for three straight decades before rising
again in 2005.

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Demand for Loanable Funds (1/4)

Demanders of loanable funds are borrowers.

Demand is driven largely by ______ that need to borrow for large

capital projects.

________________ also borrow.

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Demand for Loanable Funds (2/4)

Recall:

Borrowing must occur to build ________ goods.

This occurs before any production of final goods.

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Demand for Loanable Funds (3/4)

Movement along the demand curve for loanable funds is caused by:

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Demand for Loanable Funds (4/4)

Shift in the demand of loanable funds is caused by:

• changes in ______________________________

• changes in __________________________

• _____________________________.

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Productivity of Capital

• If capital becomes more productive, the demand for loans will

___________.

• The returns on investment (at any interest rate) will be __________.

• Example:

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Investor Confidence

What is investor confidence?

If a firm is optimistic, it will borrow more today.

Investment demand may not even be based on rational decisions or

real factors in the economy.

• Economist John Maynard Keynes referred to an investor’s drive to

action as “________________.”

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Shifts in the Demand for Loanable Funds

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Demand for Loanable Funds

Summary
Factor Direction of Effect Explanation
Productivity of capital As productivity of capital When capital becomes ______
__________, so does demand. productive, investments become
______ profitable so demand for
loans will ___________.
Investor confidence As investor confidence goes ___________ over the success
___, so does demand. of an investment will drive firms
to borrow ________.
Government borrowing As government borrowing This is covered in Chapter 15.
____________, so does
demand.

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Equilibrium in Loanable Funds Market

(1/2)
In equilibrium:

savings = investment.

• Supply of loanable funds is savings.

• Demand for loanable funds is firms wanting to borrow.

Relationship between saving and borrowing:

• Every dollar borrowed requires a dollar saved.

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Equilibrium in Loanable Funds Market

(2/2)

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Practice What You Know—5

What is true about equilibrium in the market for loanable funds?

A. Savings = investment.

B. Interest rate = inflation.

C. Investment = interest rate.

D. Savings = GDP.

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Scenario: Decline in Investor Confidence

(1/2)

Investor confidence tends to decline when the economy slows.

• Firms expect __________ sales, and investors expect ________

_________ on their _______________.

• Model predicts that this will result in a _______ level of investment

and a ________ interest rate.

• Investment fell during both U.S. recessions between 2000 and

2012.
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Scenario: Decline in Investor Confidence

(2/2)

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Future of the Loanable Funds Market in the
U.S. (1/2)
Two important factors will shape the loanable funds market in the

future:

1. Fall in the savings rate over past 30 years

____________ in time preferences would cause a ___________

supply shift.

___________ in foreign savings in the United States could shift

supply back to the _______.

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Future of the Loanable Funds Market in the
U.S. (2/2)

Two important factors will shape the loanable funds market in the

future:

2. Retirement of baby boomers

Baby boomers ____________ would cause a ___________ shift

in the supply of funds.

Result could be ______ investment and _________ GDP growth.

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Conclusion (1/2)

• Loanable funds markets channel funds from savers to borrowers.

• Supply of loanable funds: household savings

• Quantity supplied is positively related to interest rates.

• Impacted by income and wealth, consumption smoothing, and

time preferences.

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Conclusion (2/2)

• Demand of loanable funds: government and firms

• Quantity demanded is negatively related to interest rates.

• Impacted by capital productivity and investor confidence.

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