Chapter 22 Macroeconomics- Savings, Interest Rates, and the Market

Macroeconomics Chapter 22: Savings, Interest Rates, and the Market Loanable Funds Market • Loanable funds market: the market where savers supply funds for loans to borrowers o Includes stock exchanges, investment banks, mutual fund firms, etc o Basically savers put their savings in the loanable funds market which uses that money for loans for borrowers (like firms and the government) • Timeline of production: o Borrow > prepare to produce (invest, hire workers) > produce > sell output • Borrowing fuels investment, which creates future output. But notice that every dollar borrowed requires a dollar saved. • Traits of this market: o The good in this market is loanable funds. o The demanders (or consumers) are borrowers who want to invest o The suppliers are savers Interest Rates • Interest rates: the price of loanable funds, quoted as a percentage of the original loan amount • If you supply the funds (savers), the interest rate is the return you get for doing so • Final amount = original amount + (interest rate x original amount) • Interest rates can be thought of as the opportunity cost of consumption o With a 4% interest rate and a $1,000 purchase today, you are giving up the $40 you would make by saving that $1,000 • The higher the interest rate, the greater is the incentive to save. This is the loanable funds version of the law of supply: the quantity of savings rises when the interest rate rises • Profit-maximizing firms borrow to fund an investment if and only if the expected return on the investment is greater than the interest rate on the loan. • If you borrow the funds (borrowers), the interest rate is the cost of doing so o If the rate is 5%, it’s only worth it if they think the funds will allow them to make more than 5% back o The lower the interest rate, the more likely a business will succeed in earning enough to exceed the interest it will owe at the end of the year • Real interest rate: the interest rate in terms of purchasing power, the nominal interest rate corrected for inflation (inflation rises > decrease in real interest) o Can be negative • Nominal interest rate: interest rate that is not corrected for inflation o Increased by: overall increase in real interest rate or inflation • Fisher equations: o real interest rate = nominal interest rate − inflation rate o nominal interest rate = real interest rate + inflation rate • the higher the rate of inflation, the higher the nominal interest rate • Real=nominal if no inflation Factors that Shift the Supply of Loanable Funds • Income/wealth: increases in income increases savings, which shifts the loanable funds supply curve o This is true for individuals and nations o As nations gain wealth, they save more o Historically, U.S. financial markets have offered relatively greater returns than markets in other countries (also less risky) o As long as foreign funds still enter the US economy, their presence will allow more domestic firms to borrow for investment • Time preferences: people want goods, services, and money as soon as they’ve earned it o This means they have to be paid/promised a bigger return in order to save o Strong time preference=impatience > interest rates increase and equilibrium level of investment decreases, supply of loanable funds decreases • Consumption smoothing: most people prefer to consistently consume throughout life o Accomplished through the loanable funds market o Earlier in life, we spend more than we earn so we have to borrow o Midlife, or the prime earning years, is the time to repay loans and save for retirement o Dissaving: when people withdraw funds from their previously accumulated savings (associated with later life/retirement) • Shifts in the Supply of Loanable Funds: o Right: decreases in time preferences, increases in wealth, in midlife o Left: increases in time preferences, decreases in wealth, less midlife people o Also impacted by real estate value and stock market prices Factors that shift demand for loanable funds • the demand for loanable funds derives from the desire to invest or purchase capital goods that aid in future production • Productivity of capital: if the money can go farther, there’s more of a desire for loans o If capital is more productive, the demand for loans increases o Productivity can change with: ▪ New technology ▪ New facilities ▪ Cheaper workers o An increase in expected returns associated with the Internet has made computer equipment (capital) more attractive. This investment in capital yields greater returns, increasing the demand for loans. o When capital is more productive, firms are more likely to borrow to finance purchases of this type of capital. • Investor confidence: measure of what firms expect for future economic activity o If a firm believes its sales will increase in the future, it invests more today to build for future sales o Confidence is high > higher chance in current investment o John Maynard Keynes: called an investor’s drive to action “animal spirits” meaning the investment may not even be based on rational decisions or real factors • Shifts to the right: increases in capital productivity and increases in investor confidence • Shifts to the left: decreased capital productivity and decreased investor confidence Applications of the Loanable Funds Market Model • Equilibrium: occurs at the interest rate where the plans of savers match the plans of borrowers—that is, where quantity supplied equals quantity demanded o Savings=investment o Every dollar borrowed is a dollar saved o Above the equilibrium interest rate, the quantity of loanable funds demanded would be lower than the amount people are willing to save, putting downward pressure on the interest rate. • Declines in Investor Confidence o When the economy slows, investments slow o the loanable funds model predicts lower interest rates • Decreased supply of loanable funds o Retirement leads to a decrease in supply of loanable funds o Then if there are not increases in saving from other sources, interest rates will rise, leading to lower levels of investment. o this shift means lower investment (in the figure, a drop from I1 to I2) and lower GDP growth going forward Extra Notes: • During a recession, the amount of real investment and savings may both fall together, but they still remain equal. • A decrease in the demand for loanable funds tends to lower interest rates, while a decrease in supply tends to raise them. • In 1982, the savings rate was above 11%. It fell for nearly three decades before reaching a low of 2.5% in 2005. Yet, as real estate and stock prices fell throughout 2008 and 2009, the savings rate climbed back above 6%. • Decreases in investor confidence and capital productivity cause both the equilibrium interest rate and the equilibrium quantity of investment to fall • interest rate = (amount repaid-original loan amount)/ (original loan amount) • An increase in the inflow of capital into the United States increases the supply of loanable funds, as depicted below. As evident from the figure below, the result is a fall in the equilibrium interest rate and an increase in the equilibrium quantity of loanable funds. • An increase in stock prices causes household wealth to increase. Households will save more. Therefore, the supply of loanable funds will increase or shift right. • If people become less patient (time preferences rise), they will prefer to consume more today rather than save for more consumption tomorrow. People will save less. Therefore, the supply of loanable funds will fall or shift left. • If new technologies increase the productivity of machinery, a firm's expected return from investing in new capital will increase. Therefore, the demand for loanable funds will increase or shift right. • If firms become more pessimistic about the future, they might expect a decline in economic activity. Firms would want to cut back on investment. Therefore, the demand for loanable funds would decrease or shift left. • A change in the interest rate will not shift either the demand for or supply of loanable funds. Don't confuse a shift in the supply of or demand for loanable funds with a movement along a given demand or supply curve. • • • • A Investor confidence increases, and households become less patient. BCapital productivity decreases, and a greater percentage of the population shifts into retirement. CInterest rates in foreign countries decrease, and investor confidence in the United States decreases. • DA larger percentage of people move into their prime earning years, and capital productivity improves. • Suppose there is an increase in the supply of loanable funds. a. We would expect the equilibrium quantity of savings and investment to increase b. We would expect equilibrium interest rates to decrease