What happen to the Lonable fund supply and demand curves if bussiness expectation and disposable income both increase

If disposable income increases, then the supply of loanable funds would increase because people have more income available to save. For example, if the marginal propensity to save is 25%, and I get an extra $100 I save $25. But if my additional disposable income increases to $200, I save $50. An increase in supply leads to a lower real interest rate. However, if business expectations increase, the demand for loanable funds will increase. This is because firm will want to create more capital which generally requires more borrowing. An increase in the demand for loanable funds leads to a higher real interest rate. Because these have contradictory effects on interest rates, the impact is indeterminate (we don't know if interest rates will increase, decrease, or stay the same).

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Course: Macroeconomics > Unit 4

Lesson 7: The market for loanable funds

Lesson summary: the market for loanable funds

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Lesson summary

Investment spending is an important category of real GDP. Not only is it usually the most volatile part of real GDP, but investment spending on physical capital is also an important contributor to economic growth. So, if a firm wants to build a new factory, where does it get the funds to build it? Usually, firms borrow that money.

The market for loanable funds describes how that borrowing happens. The supply of loanable funds is based on savings. The demand for loanable funds is based on borrowing. The interaction between the supply of savings and the demand for loans determines the real interest rate and how much is loaned out.

Key Terms

Key term	Definition
the market for loanable funds	a hypothetical market that shows how loans from savers are allocated to borrowers who have investment projects
savings-investment spending identity	an equation that demonstrates that investment spending and savings are always equal to each other; if there is $$ 100,000$ ‍ in investment in an economy, that $$ 100,000$ ‍ has to come out of savings.
budget surplus	when taxes collected are more than the amount of government spending, the difference between taxes and government spending is a budget surplus
budget deficit	when taxes collected are less than the amount of government spending, the difference between taxes and government spending is a budget deficit
budget balance	when the amount of taxes collected is exactly equal to the amount of government spending
public saving	the difference between taxes collected and government spending; when there is a budget surplus public saving is positive, but when there is a budget deficit public saving is negative.
disposable income	income that is left for consumption after taxes are paid; if your income is $$ 100$ ‍ and you pay $$ 5$ ‍ in taxes, your disposable income is $$ 95$ ‍.
private saving	what is left of disposable income after consumption is taken out; if your disposable income is $$ 95$ ‍ and you spend $$ 70$ ‍, you have $$ 25$ ‍ left in savings.
national savings	the total amount of private saving and public saving
closed economy	an economy which does not allow international trade or the movement of financial assets into or out of a country
open economy	an economy which does allow international trade or the movement of financial assets into or out of a country
foreign funds	financial assets, such as money, that come into a country from another country; if a resident of Florin buys a bond from the government of Guilder, that purchase represents foreign funds coming into Guilder.
domestic outflow of funds	financial assets that leave a country; If a resident of Florin buys a bond from the government of Guilder, that purchase represents domestic funds flowing out of Florin.
capital inflows	financial capital coming into a country; capital inflows are equal to the inflow of foreign funds minus the outflow of domestic funds.
rate of return	percentage gain or loss on an investment or the increase or decrease in value over time; for example, if a project costs $$ 100$ ‍ to do but will generate $$ 108$ ‍ in sales, its rate of return is 8%.
demand for loanable funds	a hypothetical curve that shows the willingness to borrow money to fund investment projects; as the interest rate decreases, the quantity of loans demanded will increase.
supply of loanable funds	a hypothetical curve that shows the willingness to save money and put it into a financial intermediary.

Key Takeaways

National savings

In a closed economy, national savings is the sum of private saving and the public saving. In an open economy, national saving is the sum of private savings, the public saving, and net capital inflows.

For example, suppose the nation of Florin has:

a national income of $$ 100$ ‍ million,
taxes of $$ 10$ ‍ million,
consumption spending of $$ 60$ ‍ million
government spending of $$ 8$ ‍ million,
and net capital inflows of $$ 4$ ‍ million.

The national savings that they have available is therefore:

\begin{aligned} National savings & = P r i v a t e s a v i n g s + P u b l i c s a v i n g s + N C I \\ = ($ 100 million income - $ 10 million taxes - $ 60 million consumption) + ($ 10 million taxes - $ 8 million government spending) + $ 4 million NCI \\ = $ 30 million + $ 2 million + $ 4 million \\ = $ 36 million \end{aligned}

National savings would be

$ 36

million in Florin. That means there is

$ 36

million in savings that could be turned into loans that could fund investment spending.

The loanable funds market describes the behavior of savers and borrowers.

The market for loanable funds is a way of representing all of the potential savers and all of the potential borrowers in an economy. It has the same features of other markets that we have seen before, but with a few twists:

Quantity - loans are being “bought” and “sold” in this market. The “quantity” in this market is really the quantity of loans or, more formally, the quantity of loanable funds. Why? It’s not how many loans are being made, but how much loaning is going on.
Price - the cost of borrowing is the real interest rate, and the reward for savings is the real interest rate. Therefore, we use the real interest rate (rather than price) in the market for loanable funds.
Supply - The supply of loanable funds represents the behavior of all of the savers in an economy. The higher interest rate that a saver can earn, the more likely they are to save money. As such, the supply of loanable funds shows that the quantity of savings available will increase as the interest rate increases.
Demand - The demand for loanable funds represents the behavior of borrowers and the quantity of loans demanded. The lower the interest rate, the less expensive it is to borrow.

Equilibrium - The equilibrium in the market for loanable funds is achieved when the quantities of loans that borrowers want are the same as the quantity of savings that savers provide. The interest rate adjusts to make these equal.

Sure! Suppose there are some people in Florin who each have

$ 1000

that they are considering spending or saving. Each of them has different preferences for consumption and saving, which impacts their willingness to save. For example, Westley is very patient and willing to save money even at low-interest rates. But Humperdink would much rather spend money, so it takes a pretty high-interest rate to convince him to save:

Person	minimum interest rate needed to save $$ 1000$ ‍	Total savings available at this interest rate
Westley	1%	$$ 1000$ ‍
Buttercup	2%	$$ 2000$ ‍
Inigo	3%	$$ 3000$ ‍
Fizzig	4%	$$ 4000$ ‍
Yellin	5%	$$ 5000$ ‍
Bella	6%	$$ 6000$ ‍
Valerie	7%	$$ 1000$ ‍
Humperdink	8%	$$ 8000$ ‍

At the same time, a few of the businesses in Florin have some capital projects they would like to complete. The table below summarizes them:

Firm	Capital Project and cost	Projected return
Miracle Max’s Magic Academy	new lecturing equipment - $$ 1300$ ‍	2%
Dread Pirate Roberts’ School of Sailing	new sail $$ 1600$ ‍	3%
Count Rugen’s Rack’o’Ribs	new grill $$ 1900$ ‍	4%
Vizzini Pharma	develop iocaine antidote $$ 2000$ ‍	5%
Yeste’s Sword o'Rama	new foundry $$ 3000$ ‍	6%

For all of these potential borrowers, they would be willing to pay up to their expected return in interest, but not more. We can organize this to represent the amount of funds that people would want to borrow and save at various interest rates:

Real interest rate	QD LF	QS LF
1%	$$ 1300$ ‍ + $$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 10, 000$ ‍	$$ 1000$ ‍
2%	$$ 1300$ ‍ + $$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 10, 000$ ‍	$$ 2000$ ‍
3%	$$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 8, 700$ ‍	$$ 3000$ ‍
4%	$$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 7100$ ‍	$$ 4000$ ‍
5%	$$ 2000$ ‍ + $$ 3000$ ‍ = $$ 5, 000$ ‍	$$ 5000$ ‍
6%	$$ 3, 000$ ‍	$$ 6, 000$ ‍

How does the interest rate adjust? Suppose the real interest rate is currently 10%. Only Yeste would be willing to borrow money, but everyone would want to supply their savings at this interest rate. There would be surplus savings available to loan out. This surplus will put downward pressure on the interest rate. As the interest rate decreases, fewer people want to save, but more businesses want to borrow. The interest rate continues to adjust until the market for loanable funds clears.

In this market, the equilibrium would be a real interest rate of 5% and the quantity of loanable funds loaned would be

$ 5, 000

Changes in the demand for loanable funds

Anything that changes investment demand will change the demand for loanable funds. Examples of events that can shift the demand for loanable funds are

Changes in the anticipated rate of return earned on investment spending
Government policies

There is an important implication of that first determinant of investment demand: real interest rates are procyclical. When the economy is doing well, the rate of return on any investment spending will increase. That means the demand for loanable funds will increase, which leads to a higher real interest rate. In other words, we would expect to see an increase in real interest rates, and the quantity of loans made, when the economy is doing well.

Some government policies, such as investment tax credits, basically lower the cost of borrowing money at every real interest rate. Such policies would increase the demand for loanable funds. Other policies, such as budget deficits, might increase the demand for loanable funds.

Changes in the supply of loanable funds changes

Anything that impacts savings behavior impacts the supply of loanable funds. Some examples of that are:

Changes in saving behavior, such as preferences for saving or having more wealth
Changes in capital inflows
Changes in public savings

Do deficits cause a shift in supply or demand?

That’s an interesting question! There are actually two points of view:

Deficits increase the demand for loanable funds; surpluses decrease the demand for loanable funds. The logic of this point of view is that if the government runs a deficit, it has to borrow money just like everyone else. So, if there is a deficit, the demand for loanable funds will increase because the government gets in line to borrow money just like all of the other borrowers.
Deficits decrease the supply of loanable funds; surpluses increase the supply of loanable funds. The logic of this point of view is that national savings includes public savings (T-G), and national savings is the source of the supply of loanable funds. So anything that makes T-G smaller (like a deficit) or bigger (like a surplus) will shift the supply of loanable funds

But that doesn’t mean both curves shift? Supply and demand do not have the same determinants in any market. Your graphical model should reflect only one point of view.

In the end, both points of view have the same impact on the real interest rate: deficits increase the real interest rate and surpluses decrease the real interest rate.

The Fisher Effect

The Fisher effect states that an increase in expected future inflation will increase nominal interest rates by exactly the amount of expected inflation. Expected inflation will have no impact on either the quantity of loanable funds or the real interest rate.

For example, suppose the current rate of inflation is 2% and the real interest rate is 5%. Then the current nominal interest rate is 7%:

\begin{aligned} Nominal interest rate & = real interest rate + inflation \\ = 5 % + 2 % \\ = 7 % \end{aligned}

If people expect inflation to decrease by 1%, then both savers and borrowers will take this into account, and they will incorporate this into their expected rate of inflation:

\begin{aligned} Nominal interest rate & = real interest rate + inflation \\ = 5 % + (- 1) % \\ = 4 % \end{aligned}

Key graphical models

The market for loanable funds

The market for loanable funds shows the supply of savings and the demand for loans. The real interest rate adjusts until the quantity of savings supplied is equal to the quantity of loans demanded.

Key equations

The savings and investment identity

S = I

The savings and investment identity states that all investment spending must be is done from savings.

This identity doesn’t appear out of thin air, it comes from national income. Let’s start with the fact that national income (Y) is equal to aggregate expenditures:

Y = C + I + G + N X

To make things simpler, let’s assume that the economy is a closed economy. That means that there is no international trade and there is no movement of financial assets into or out of a country. So, the NX disappears from our national income:

Y = C + I + G

Notice the “

I

”? That is investment spending from our savings and investment identity! So, let’s isolate “

I

” so it is on its own in the equation:

Y - C - G = I

Before we can break this down further, we need to recognize that government spending is paid using taxes. Taxes are taken out of income, and then government spending is taken out of taxes, as shown in the equation below:

Y - T - C + T - G = I

We are left with two components of national saving: private saving (Y-T-C) and public saving (T-G).

Ok, so what if this is an open economy, not a closed economy? In that case, we have to allow for the possibility that some of these savings on the left-hand side of the equation will go overseas, or that some savings will come overseas into this economy. So, we also need to include net capital inflows (

N C I

Y - T - C + T - G + N C I = I

The left-hand side of the equation shows the total amount of savings available. We can break it down into three components:

Component	Source of funds
$Y - T - C$ ‍	Private savings: The amount leftover after consumption is deducted from disposable income
$T - G$ ‍	Public savings: The amount of budget surplus or budget deficit
$N C I$ ‍	Net capital inflows: the difference between financial capital entering the country and financial capital leaving the country.

Common misperceptions

It might seem strange that we are using the word “investment” to talk about borrowing money when people usually use the word “investment” as a place to put their savings. Remember that in economics the word “investment” refers to spending by businesses on physical capital, inventories, and other business expenditures. That business capital will require borrowing, so investment requires loans.
The Fisher effect describes a change in nominal interest rates, not real interest rates. Expected inflation will be incorporated into the nominal interest rates, but the real interest rate is not impacted by inflation.

Review Questions

In a correctly labeled graph of the loanable funds market, show the impact of an increase in national savings on the interest rate.
The economy of Florin has a balanced budget. They then experience the negative demand shock shown here:

If there are automatic stabilizers, will the budget move into a deficit, surplus, or budget balance? Explain
Show the impact on the interest rate of the change you indicated in part (a) on a correctly labeled graph of the market for loanable funds.

The budget will move to a deficit. The graph shown indicates that the economy moved into a recession. When there are automatic stabilizers, a recession will cause taxes to decrease and government spending to increase. This will cause a deficit.
There are two possible correct answers, but both should show an increase in the interest rate.

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Aman Bhardwaj
Posted 6 years ago. Direct link to Aman Bhardwaj's post “What happen to the Lonabl...”
What happen to the Lonable fund supply and demand curves if bussiness expectation and disposable income both increase
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(6 votes)
Answer
- melanie
  Posted 6 years ago. Direct link to melanie's post “If disposable income incr...”
  If disposable income increases, then the supply of loanable funds would increase because people have more income available to save. For example, if the marginal propensity to save is 25%, and I get an extra $100 I save $25. But if my additional disposable income increases to $200, I save $50. An increase in supply leads to a lower real interest rate.
  
  However, if business expectations increase, the demand for loanable funds will increase. This is because firm will want to create more capital which generally requires more borrowing. An increase in the demand for loanable funds leads to a higher real interest rate.
  
  Because these have contradictory effects on interest rates, the impact is indeterminate (we don't know if interest rates will increase, decrease, or stay the same).
  Button navigates to signup page
  (10 votes)
labautista0512
Posted 8 months ago. Direct link to labautista0512's post “What would happen if taxe...”
What would happen if taxes increased but government spending remained the same. How would this affect the supply and demand of loanable funds?
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(2 votes)
Answer
Miracle Guy
Posted 4 years ago. Direct link to Miracle Guy's post “How did the person did th...”
How did the person did that
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(1 vote)
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- Maverick M.
  Posted a year ago. Direct link to Maverick M.'s post “They did it with that the...”
  They did it with that their
  Comment on Maverick M.'s post “They did it with that the...”
  (2 votes)
Yohannes Wondimu
Posted 4 years ago. Direct link to Yohannes Wondimu's post “One of the practice quest...”
One of the practice questions asks:

"In response to a particularly severe stock market crash in Burginville, business optimism is at an all-time low, and the demand for capital has decreased. What will be the impact of a decrease in the demand for capital on the market for loanable funds and the stock of capital in Burginville?"

The answer was "Demand for loanable funds will decrease; stock of capital will decrease."

I get why the demand would decrease. But wouldn't the stock of capital goods remain the same? Since no capital was destroyed (eg by war)? Sure the rate of increase in stock of capital would decrease, but the answer states that the stock itself would go down.

I think the stock would be unchanged, it might even increase slightly (since firms are still borrowing SOME money to buy SOME additional stocks). No?
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(2 votes)
Answer
- gosoccerboy5
  Posted 4 years ago. Direct link to gosoccerboy5's post “You do make a good point,...”
  You do make a good point, Yohannes. However, it is more concise to say 'stock of capital will decrease' than to say 'stock of capital will likely not increase as fast as it would in normal times.' Also you need to factor in depreciation of the capital stock.
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Fiona McIntosh
Posted 4 years ago. Direct link to Fiona McIntosh's post “What would happen to the ...”
What would happen to the demand of loanable funds if personal income taxes increased? Would it increase because people now need more money, or would it decrease because people won't be taking out loans since they have less money?
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(2 votes)
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- Uma
  Posted 4 years ago. Direct link to Uma's post “Actually, the supply of l...”
  Actually, the supply of loanable funds will decrease.
  
  As people's savings will decrease due to increase of income taxes. So, they will save less and supply less.
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  (0 votes)
shaunit.bajoria
Posted 17 days ago. Direct link to shaunit.bajoria's post “If taxes decrease and gov...”
If taxes decrease and government spending increases, then people will have more money to spend --> the supply of money will increase. So, in the last example's possibility 1 should Supply increase and not decrease
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(1 vote)
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Steven Klurfeld
Posted 3 years ago. Direct link to Steven Klurfeld's post “whats an easy way to expl...”
whats an easy way to explain the relationship between the interest rate derived from the Money Market graph, and the interest rate derived from the loanable funds graph?Thanks!
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(1 vote)
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- Noah L.
  Posted 3 years ago. Direct link to Noah L.'s post “So, the money market show...”
  So, the money market shows how the nominal interest rate adjusts to changes in the money supply done by the Fed. However, the market for loanable funds shows the relationship between real returns on savings and the real price of borrowing (real interest rate) with the publics willingness to borrow and save. This means that the two interests rates between the money market graph and the loanable fund graph are different, because one is nominal and the other is real.
  However, we can make the money market graph by dividing M/P to make it real, changing it to represent he real interest rate.
  Now, you can connect the two graphs by shocking one of the models and seeing how the change of real interest rates affects the other.
  For example, if the Fed conducts open market operations to increase the money supply, the real interest rate would fall. Since a decrease in the real interest rate incentivizes firms and households to take money out of the bank, since they aren't making as much off of interest as they once were, the supply of loanable funds would decrease. This is because of the relationship between the real interest rate and the supply of loanable funds.
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M.J.G.
Posted 4 years ago. Direct link to M.J.G.'s post “How does I = S connect to...”
How does I = S connect to the loanable funds market graph? Is S (and therefore I) the supply curve because it's the amount of savings? Is it the demand curve because it's the amount of loan money needed to fund economic investments? Is it representative of an entire curve, or just a point along one of the curves?
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- gosoccerboy5
  Posted 4 years ago. Direct link to gosoccerboy5's post “I=S refers to the fact th...”
  I=S refers to the fact that investment is equal to savings. S is the supply curve and I is a large portion of the demand curve (the rest mainly being credit card borrowing and government debt).
  
  This directly ties into the market for loanable funds because I=S is the same as the equilibrium in the market for loanable funds.
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  (1 vote)
mia harrell
Posted 2 years ago. Direct link to mia harrell's post “hey does anyone know what...”
hey does anyone know what federal receipts, fiscal receipts, and outlays are?
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