The market for loanable funds

This post is based on the market for loanable funds as it is presented in Gregory Mankiw's introductory textbook.

It looks at the market for loanable funds which determines the short-run interest rate.

The idea of this topic is to get rudimentary understanding of how interest rates are determined in the short-run.  It is also useful to show how the market allocates savings and investments in the economy.

market_for_loanable_funds

In the diagram above, you can see that the supply of loanable, which is the countries savings, is upward sloping. That tells us that the higher the interest rate, which should be thought of how much you earn for saving, the more people are willing to save. It also tells us that the demand for savings is downward sloping, which says the cheaper money is to borrow, the more likely people are to borrow.

Assumptions

  • The interest rate is the same for borrowers and lenders.
  • There is only one lending institution who charges the one interest rate (thus there are no share markets etc. which is unrealistic but a good simplification to get a base understanding).
  • The economy is a closed economy - i.e there is no interactions with overseas countries.

Factors which influence demand

The demand for loanable funds depends on how much people want to invest.

It is important to note that in macroeconomics, invest means spending money on building factories and equipment for producing goods within the economy and not buying shares etc. (remember, the only place you can invest within this economy is the market for loanable funds).

 

Factors which influence supply

S = Y - C - G

where

Y is the total income of the country

C is how much of the country spends on consuming goods

G is how much the government spends on consuming goods

Savings should be thought as of the money left over after the government and people have consumed goods.

From this we can infer that anything which causes consumers to spend less on consumption will lead to a higher level of savings and also anything which leads to the government reducing its spending (thus, them saving their tax revenue) will also increase the supply of savings.

The main question you should be asking yourself before conducting supply-and-demand analysis on the market for loanable funds is "will this change how much people save, or how much they invest". If it affects savings, you should shift supply. If it affects investment, you should move demand.

What factors shift demand to the left - a reduction in demand?

  • Increased tax on investment earnings

supply_of_loanable_funds_negative_demand_shift

A negative shock to demand causes the demand curve to shift to the left. This reduces the interest rate and decreases the quantity of loanable funds.

What factors shift demand to the right - an increase in demand?

  • Increased tax on consumption
  • Tax benefits for savings

supply_of_loanable_funds_positive_demand_shock

When the economy experiences a positive shock to demand, this causes the demand curve to shift to the right. This causes the interest rate to increase and the quantity of loanable funds to also increase.

What factors shift supply to the left - a reduction in supply?

  • Government running a deficit (this is called 'crowding out' affect because the government crowds out the private sector)

supply_of_loanable_funds_negative_supply_shock

A negative supply shock shifts the supply curve to the left. This causes the interest rate to increase and the quantity of loanable funds to decrease.

What factors shift supply to the right - an increase in supply?

  • Governments running a surplus

supply_of_loanable_funds_positive_supply_shock

A positive supply shock causes the supply curve to shift to the right. This causes the interest rate to decrease and the quantity of loanable funds to decrease.

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