8 Saving, Investment, and the Financial System (Part 2)

THE MARKET FOR LOANABLE FUNDS

•Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

•The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

•Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Supply and Demand for Loanable Funds

•The supply of loanable funds comes from people who have extra income they want to save and lend out.

•The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Supply and Demand for Loanable Funds

•The interest rate is the price of the loan.

•It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.

•Financial markets work much like other markets in the economy.

• The equilibrium of the supply and demand for loanable funds determines the real interest rate.

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Figure 1 The Market for Loanable Funds

Supply and Demand for Loanable Funds

•Government Policies That Affect Saving and Investment

• Taxes and saving

• Taxes and investment

• Government budget deficits

Policy 1: Saving Incentives

•Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Policy 1: Saving Incentives

•A tax decrease increases the incentive for households to save at any given interest rate.

• The supply of loanable funds curve shifts to the right.

• The equilibrium interest rate decreases.

• The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable Funds

Policy 1: Saving Incentives

•If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Policy 2: Investment Incentives

•An investment tax credit increases the incentive to borrow.

• Increases the demand for loanable funds.

• Shifts the demand curve to the right.

• Results in a higher interest rate and a greater quantity saved.

Policy 2: Investment Incentives

•If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Figure 3 An Increase in the Demand for Loanable Funds

Policy 3: Government Budget Deficits and Surpluses

•When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.

•The accumulation of past budget deficits is called the government debt.

Policy 3: Government Budget Deficits and Surpluses

•Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms.

•This fall in investment is referred to as crowding out.

• The deficit borrowing crowds out private borrowers who are trying to finance investments.

Policy 3: Government Budget Deficits and Surpluses

•A budget deficit decreases the supply of loanable funds.

• Shifts the supply curve to the left.

• Increases the equilibrium interest rate.

• Reduces the equilibrium quantity of loanable funds.

Figure 4: The Effect of a Government Budget Deficit

Policy 3: Government Budget Deficits and Surpluses

•When government reduces national saving by running a deficit, the interest rate rises and investment falls.

Policy 3: Government Budget Deficits and Surpluses

•A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Figure 5 The U.S. Government Debt

Summary

•The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds.

•All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.

•National income accounting identities reveal some important relationships among macroeconomic variables.

•In particular, in a closed economy, national saving must equal investment.

•Financial institutions attempt to match one person’s saving with another person’s investment.

•The interest rate is determined by the supply and demand for loanable funds.

•The supply of loanable funds comes from households who want to save some of their income.

•The demand for loanable funds comes from households and firms who want to borrow for investment.

•National saving equals private saving plus public saving.

•A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds.

•When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.