Loanable Funds Market

1. Loanable Funds Market

2. The Circular Flow Diagram • Four key markets coordinate the circular flow of income. • The resource marketcoordinates the actions of businesses demanding resources and households supplying them in exchange for income. • The goods & services market coordinates the demand for and supply of domestic production (GDP). • The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. • The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments.

3. Realinterest rate Moneyinterest rate – = Loanable Funds Market • The interest rate coordinates the actions of borrowers and lenders. • From the borrower's viewpoint, interest is the cost paid for earlier availability. • From the lender’s viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future. • The money and real interest rate: • When inflation is anticipated, lenders will demand (and borrowers pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar. • This premium for the expected decline in purchasing power of the dollar is called the inflationary premium. Inflationarypremium

4. Here, the moneyand real interestrates are equal i = r = Inflation and Interest Rates Loanable Fundsmarket InterestRate S (stable prices expected) .05 D (stable prices expected) Quantityof funds Q • Suppose that when people expect the general level of prices to be stable (zero inflation) in the future, a 5% interest rate brings equilibrium in the loanable funds market. • Under these conditions, the money and real interest rates will be equal (here 5%).

5. S (5% inflation expected) Inflationary premiumequals expectedrate of inflation i = .10 D (5% inflation expected) Inflation and Interest Rates Loanable Fundsmarket InterestRate S (stable prices expected) .05 r = D (stable prices expected) Quantityof funds Q Q • When people expect prices to rise at a 5% rate, the money interest rate (i) will rise to 10% even though the real interest rate (r) remains constant at 5%.

6. Capitalinflow D2 Capitaloutflow D1 Interest Rates and Capital Flows Loanable Fundsmarket Domesticsaving InterestRate Supply ofloanablefunds r2 r0 r1 D0 Quantityof Funds Q0 Q2 Q1 • Demand and supply in the loanable funds market will determine the interest rate. • When demand for loanable funds is strong (D2), real interest rates will be high (r2) and there will be a inflow of capital. • In contrast, weak demand (D1) and low interest rates (r1) will lead to capital outflow.

7. - + = + Budget Deficit Exports Imports Investment Net Saving GovernmentPurchases - - = + + Taxes Exports Imports Investment Net Saving GovernmentPurchases + = + + + Investment Imports Taxes Exports Net Saving Leakages Injections Leakages and Injections from the Circular Flow of Income • Budget deficit = (government purchases - taxes): • Which may be re-written as: • Therefore, when the loanable funds and foreign exchange markets are in equilibrium, leakages from the circular flow of income (savings + imports + taxes) are equal to injections into it (investment + government purchases + exports).

8. injections leakages The Circular Flow Diagram • Macro equilibrium will be present when the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop). • This condition will be present when the (investment, government purchases, & exports) into the circular flow … equal the(saving, taxes, and imports) from it. • Hence, when equilibrium is present in the loanable funds and foreign exchange markets, injections equal leakages and Macro equilibrium will be present.