Module 1.2 Flashcards
Loanable Funds Theory (1 of 8)
The Loanable Funds Theory suggests that the
market interest rate is determined by the factors that
control supply of and demand for loanable funds.
▪ Can be used to explain:
▪ Movements in the general level of interest rates in a
particular country
▪ Why interest rates among debt securities of a given
country vary
Household Demand for Loanable Funds
Households demand loanable funds to
finance housing expenditures as well as the
purchase of automobiles and household
items.
▪ Inverse relationship between the interest rate
and the quantity of loanable funds demanded
(Exhibit 2.1)
Business Demand for Loanable Funds
Depends on number of business projects to be implemented. More demand at lower interest rates. (Exhibit 2.2) NPV-net value of project k =required rate of return on project CF1 =cash flow in period 1 INV =initial investment NPV =net present value of project (1 ) 1
k C F t INV NPV k C F NPV IN
Government Demand for Loanable Funds
Governments demand loanable funds when
planned expenditures are not covered by
incoming revenues.
▪ Government demand is said to be interest
inelastic — insensitive to interest rates.
Expenditures and tax policies are
independent of the level of interest rates.
(Exhibit 2.3)
Foreign Demand for Loanable Funds
A country’s demand for foreign funds depends on the interest
rate differential between the two.
▪ The greater the differential, the greater the demand for foreign
funds.
▪ The quantity of U.S. loanable funds demanded by foreign
governments will be inversely related to U.S. interest rates.
(Exhibit 2.4)
Aggregate Demand for Loanable Funds
The sum of the quantities demanded by the separate sectors at
any given interest rate. (Exhibit 2.5)
Supply of Loanable Funds
Households are largest supplier, but some supplied by
government units.
▪ More supply at higher interest rates.
▪ Supply by buying securities.
▪ Effects of the Fed — By affecting the supply of
loanable funds, the Fed’s monetary policy affects
interest rates.
▪ Aggregate supply of funds — Is the combination of all
sector supply schedules along with the supply of funds
provided by the Fed’s monetary policy. (Exhibit 2.6)
Equilibrium Interest Rate – Algebraic Presentation
Aggregate Demand for funds (DA ) DA = Dh + Db + Dg + Dm + Df Dh = household demand for loanable funds Db = business demand for loanable funds Dg = federal government demand for loanable funds Dm = municipal government demand for loanable funds Df = foreign demand for loanable funds ▪ Aggregate Supply of funds (SA ) SA = Sh + Sb + Sg + Sm + Sf Sh = household supply for loanable funds Sb = business supply for loanable funds Sg = federal government supply for loanable funds Sm = municipal government supply for loanable funds Sf = foreign supply for loanable funds
Equilibrium Interest Rate — Graphical Presentation
Combining aggregate demand and aggregate
supply curves (Exhibits 2.5 and 2.6) allows
comparison of total amount demanded to total
amount supplied
▪ At equilibrium interest rate i, the supply of
loanable funds is equal to the demand for loanable
funds. (Exhibit 2.7)
▪ At interest rate above i, there is a surplus of
loanable funds.
▪ At interest rate below i, there is a shortage of
loanable funds.
Factors That Affect Interest Rates (1 of 3)
Impact of economic growth on interest rates:
▪ Puts upward pressure on interest rates by shifting demand for
loanable funds outward. (Exhibits 2.8 & 2.9)
Impact of inflation on interest rates:
▪ Puts upward pressure on interest rates by shifting supply of
funds inward and demand for funds outward. (Exhibit 2.10)
▪ Fisher effect: i = E(INF) + iR
where i = nominal or quoted rate of interest
E(INF) = expected inflation rate
iR = real interest rate
Impact of Monetary Policy on Interest Rates
When the Fed reduces (increases) the money supply, it reduces
(increases) the supply of loanable funds, putting upward
(downward) pressure on interest rates.
Impact of the Budget Deficit on Interest Rates
Crowding-out Effect: Given a certain amount of loanable funds
supplied to the market, excessive government demand for funds
tends to “crowd out” the private demand for funds. (Exhibit
2.11)
Impact of Foreign Flows of Funds on Interest Rates
Interest rate for a certain currency is determined by the demand
for funds in that currency and the supply of funds available in
that currency. (Exhibit 2.12)
Summary of Forces that Affect Interest Rates
Economic conditions are the primary forces behind
a change in the supply of savings provided by
households or a change in the demand for funds by
households, businesses, or the government.
▪ The demand for funds in the United States is indirectly
affected by U.S. monetary and fiscal policies because
these policies influence economic growth and inflation,
which in turn affect business demand for funds. Fiscal
policy determines the budget deficit and therefore
determines the federal government demand for funds.
(Exhibit 2.13)
Forecasting Interest Rates (Exhibit 2.14)
Net Demand (ND) should be forecast: ND = DA – SA ND = (Dh + Db + Dm + Dr ) – (Sh + Sb + Sm + Sf ) ▪ Future Demand for Loanable Funds depends on future: ▪ Foreign demand for U.S. funds ▪ Household demand for funds ▪ Business demand for funds ▪ Government demand for funds ▪ Future Supply of Loanable Funds depends on: ▪ Future supply by households and others ▪ Future foreign supply of loanable funds in the U.S.
