The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment.. The Worked Problem explores the loanable funds market by
Trang 1W H AT I S E C O N O M I C S ? 5 9
T h e B i g P i c t u r e
Where we have been:
This chapter builds on the
definition of real GDP from Chapter 4 to explain how investment is financed It also uses the demand and supply model explained in Chapter 3 The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment It also discusses how government actions affect this market
Where we are going:
Chapter 7 is the second of four chapters that examine the economy in the long run when the economy is at full employment The following chapters focus on money and the price level, and the exchange rate and balance of payments After these chapters the next section examines macroeconomic fluctuations by
developing the AS-AD model The material presented in Chapter 7 is used in
many of the following chapters For instance the result that the real interest rate is determined in the loanable funds market is important in the next chapter to help determine the long-run effects from changes in the quantity of money The loanable funds model also is used in Chapter 13 when examining the supply-side effects of fiscal policy
N e w i n t h e Tw e l f t h E d i t i o n
A substantial change in this chapter is the omission of the global financial market section which has been moved to Chapter 9 The chapter now concentrates
exclusively on the domestic loanable funds market There also have been
substantial changes to the Economics in Action boxes in this chapter reflecting data and events that have occurred since 2008 but the main content and flow of the chapter is very similar to the 11th edition The Federal Reserve was added as a key financial institution The first Economics In Action box has been expanded with new graphs added highlighting home mortgage debt Two new Economics In Action boxes show real vs nominal interest rates and the allocation of loanable funds to various agents The Global Loanable Funds Market Section has been moved to chapter 9 The Economics In The News has 2014 article discussing interest rates on government bonds The Worked Problem explores the loanable funds market by giving data on the nominal interest rate, real interest rate,
investment, and government budget deficit in 2005 and 2007 The questions ask the students the inflation rate in the two years, how the price of bonds changed between the years, and what happened to the demand for loanable funds
between the years It also asks them about crowding out and its effect on saving
AND
C h a p t e r
59
Trang 2and investment To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems
60
Trang 3L e c t u r e N o t e s
Finance, Saving, and Investment
quantity of loanable fund and investment
investment
I Financial Institutions and Financial Markets
Finance and Money; Capital and Financial Capital
• Finance refers to providing the funds used for investment.
• Money refers to what is used to pay for goods and services.
• Capital and financial capital differ:
and other items that have been produced in the past and that are used to today
to produce goods and services
• Financial capital is the funds that firms use to buy physical capital.
Definitions and the meaning of investment in economics The student has met the
key definitions of investment in this chapter, but to be absolutely sure that they are
remembered it is worth emphasizing that in economics, “capital” and “investment”
without any qualification mean physical capital and purchase of newly produced physical capital goods Everyday usage of investment as the purchase of stocks or bonds can lead
to confusion So it is worth getting these matters clear right from the start
Capital and Investment; Wealth and Saving
investment is the total amount spent on new capital; net investment is the
change in the capital stock Net investment equals gross investment minus
depreciation
A concrete understanding of stock and flow variables is an important building block to understanding economic principles You can use “buckets” to convey the relationship between stock and flow variables Buckets are easy to draw along with a simple faucet and hole in the bucket You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket You can extend the use of buckets
to any stock/flow concept, such as wealth and saving For use with the capital stock, draw
a bucket with a “K” on it At a point in time there is fixed amount of capital in the bucket Over some time period, investment flows in the top and depreciation flows out The net effect of these two flows leaves the bucket higher or lower at the end of that time period
• Wealth is the value of all the things people own; saving is the amount of income
not paid in taxes or spent on consumption Saving adds to wealth Wealth also changes when the market value of wealth changes
Financial Capital Markets
Financial markets transform saving and wealth into investment and capital
for inventories, purchasing houses, and so forth can be obtained in this market
bond is a promise to make specified payments on specified dates One type of bond
is a mortgage-backed security, which entitles its owner to the income from a
package of mortgages The failure of many mortgage-backed securities to make
Trang 4their specified payments was a factor leading to the financial crisis in 2007 and
2008
of ownership and a claim to the firm’s profit
Financial Institutions
financial capital by being a borrower in one market and a lender in another market Financial institutions include, commercial banks, government-sponsored mortgage
lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies
Financial Crisis: The Economics in Action section studies the Fall of 2008 and the biggest
financial crisis since the Great Depression Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent These institutions,
such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large”
to fail While you cannot fully explain the reasons why failure of a large financial institution
might have external costs, your students can readily appreciate the point that if these
institutions failed many borrowers would find it significantly more costly to arrange loans
The government acted in most all of these cases by arranging a bailout in form or another Some companies were given government loans (AIG received an $85 billion loan from the
Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others
were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial
institutions were given government assistance in the form of government loans and/or
government purchase of stock
Insolvency and Illiquidity
the market value of what it has borrowed If the net worth is positive, the institution
is solvent and can remain in business If the net worth is negative, the institution is
insolvent and might go out of business.
because it does not have enough available cash A firm can be illiquid but solvent
Interest Rates and Asset Prices
• The interest rate on a financial asset is equal to the interest paid on the asset
expressed as a percentage of the asset’s price
• If an asset’s price is $50 and it pays $2.50 in interest, the interest rate is
$2.50
$50.00 × 100 = 5.0 percent
• If the price of the asset rises, the interest rate falls Conversely if the interest rate falls, the price of the asset rises
It is helpful to show explicitly how the market price of a bond is determined by the current
interest rate Using an example of government bond will be useful for future chapters on
monetary and fiscal policy Explain that a bond is an “IOU” from the issuer and its basic
components of are its term, face value and coupon payment For example, a bond might
have a $10,000 face value with a coupon payment of $500 for the next 5 years Point out
to your students that this coupon payment means that the bond is essentially paying an
interest rate of 5 percent for the next five years…at least as long as its price is $10,000
Explain how the bond can be traded in the secondary market and ask them what they
think the bond’s price would be if the market interest rate rose to 6 percent Make clear
that when the interest rate rises to 6 percent, which means that “new” government bonds
Trang 5
with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen from $10,000 to something less In other words, an increase in the interest rate has lowered the price of (old) bonds!
6 8 C H A P T E R 7
Trang 6II The Loanable Funds Market
The loanable funds market is the aggregate of all the individual financial markets In this
market households, firms, governments, banks, and other financial institutions lend and
borrow
Funds that Finance Investment
budget surplus, and international borrowing
government minus transfer payments received from the government): Y = C + S +
T GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X
− M) Combining shows that C + S + T = C + I + G + (X − M), which can be
rearranged to show how investment is financed:
I = S + (T − G) + (X − M).
This formula shows that investment is financed using private saving, the
M).
saving.
the rest of the world
rest of the world
The Real Interest Rate
lender receives expressed as a percentage of the number of dollars borrowed or lent
The real interest rate is the nominal interest rate adjusted to remove the effects
of inflation on the buying power of money The real interest rate is approximately
equal to the nominal interest rate minus the inflation rate The real interest rate is
the opportunity cost of loanable funds
Giving a numeric example of why the real interest rate and nominal interest rate differ can
be enlightening for your students Suppose you have $100 this year and you can invest it
at a (nominal) interest rate of 10 percent One year later you will have $110, that is, 10
percent more dollars If the price of a cheeseburger is $1 this year you can buy 100
cheeseburgers But if one year later the price level rose from 100 to 108 and the price of
cheeseburgers rose at this average rate, then the cheeseburgers will cost you $1.08 Next
year your $110 will only buy about 102 cheeseburgers ($110/$1.08) The purchasing power
of your 10 nominal interest rate is only about 2 more cheeseburgers, a 2 percent real
interest rate!
Real versus nominal interest rate To drive home the distinction between the nominal
interest rate and real interest rate, ask your class if an interest rate of 10 percent is high
Almost assuredly they will respond with a resounding “Yes.” Point out to them that around
1980 a 10 percent interest rate was exceedingly low At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length
of the loan What accounts for the difference between then and now? The answer is simple: inflation In 1980 the inflation rate was running at more than 10 percent per year Given
the high inflation rate, the nominal interest rate adjusted so that it, too, was high Most of
the dollars lenders received as (nominal) interest went to keeping their purchasing power
intact But the real interest rate at that time was not much different than the real interest
rate nowadays In other words, the increase in purchasing power received by lenders (the
Trang 7
real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today
The Demand for Loanable Funds
finance investment, the government budget deficit, and international investment or lending during a given time period Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment
investment only if they expect to earn a profit
loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same
• The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate
more investment firms make Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism
The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward
The Supply of Loanable Funds
private saving, the government budget surplus, and international borrowing during
a given time period Saving makes up the majority of the loanable funds available,
so the initial focus is on saving
funds supplied and the real interest rate when all other influences on lending plans remain the same
increases As illustrated in the figure, the supply of loanable funds curve is upward sloping
increases, when wealth decreases, when expected future income decreases, and when default risk decreases When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward
Equilibrium in the Loanable Funds Market
real interest rate sets the quantity of
loanable funds demanded equal to the
figure, the equilibrium real interest
rate is 5 percent and the equilibrium
quantity of loanable funds is $2.0
trillion
Changes in Demand and Supply
change the real interest rate and the
7 0 C H A P T E R 7
Trang 8price of financial assets
equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase
• If the supply of loanable funds increases, the equilibrium real interest rate falls
and the equilibrium quantity of loanable funds and investment increase
the real interest rate also can be sharp But in the long run the demand and
supply grow at the same pace so there is no upward or downward trend in the
real interest rate
home price bubble that helped lead to the financial crisis Between 2001 and 2005, a massive increase in the supply of loanable funds lowered the real interest rate and
led to many people purchasing homes As the price of homes rose, the demand for
loanable funds increased to try to take advantage of the price rise The increase in
the demand increased the real interest rate, which put many homeowners in
financial difficulty and ultimately lead to defaults and foreclosures
III Government in the Loanable Funds Market
A Government Budget Surplus
shift the supply of loanable funds curve In
the figure, PSLF is the private supply of
loanable funds curve The government has
a budget surplus equal to the length of the
arrow ($0.4 trillion) The surplus adds to
private saving and so the supply of
loanable funds curve becomes SLF.
Without the budget surplus, the real
interest rate is 6 percent and the quantity
of loanable funds and investment is $2.0
trillion; with a budget surplus, the real
interest rate is 5 percent and the quantity
of loanable funds and investment is $2.2
trillion
A Government Budget Deficit
the figure, PDLF is the private demand for
loanable funds curve The government has
a budget deficit equal to the length of the
arrow ($0.4 trillion) The deficit adds to
private demand and so the demand for
loanable funds curve becomes DLF.
Without the budget deficit, the real interest
rate is 5 percent and the quantity of
loanable funds and investment is $2.0
trillion; with the budget deficit, the real
interest rate is 6 percent, the quantity of
loanable funds is $2.2 trillion, and
investment is $1.8 trillion
deficit to decrease investment is called a
Trang 9
crowding-out effect.
the increase in the demand for loanable funds is called the Ricardo-Barro effect
The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit To the extent that the Ricardo-Barro effect occurs, it
reduces the crowding-out effect because the SLF curve shifts rightward to offset the
deficit
The Economics in the News section examines how interest rates on government securities fell during 2014 The analysis points out that the supply of loanable funds increased in
2014 while the demand decreased These changes lowered the real interest rate
7 2 C H A P T E R 7
Trang 10A d d i t i o n a l P r o b l e m s
a If there is no Ricardo-Barro effect, explain how loanable funds, saving,
investment, and the real interest rate respond to this fiscal policy
b How does your answer in part a depend on the strength of the Ricardo-Barro effect?
funds The government is running a
budget surplus of $900 billion
a Show the effect of a $400 billion
decrease in the government budget
surplus if there is no Ricardo-Barro
effect How much investment is crowded
out by the fall in the surplus?
b How does the Ricardo-Barro effect
change the results?
3 IMF Warning Over Slowing Growth
Turmoil in the world’s financial markets may well slow global economic
growth
BBC News, October 10, 2007
Explain how turmoil in global financial markets might affect the demand for
loanable funds, investment, and global economic growth in the future
S o l u t i o n s t o A d d i t i o n a l P r o b l e m s
1 a The decrease in government expenditure by $100 billion increases the supply of
loanable funds, which increases the equilibrium quantity of loanable funds
Compared to what otherwise would have been the case, the decrease in government expenditure lowers the real interest rate and increases investment
b The stronger the Ricardo-Barro effect, the less the increase in the supply of loanable funds as taxpayers expect future taxes to be lower due to the decrease in
government expenditures The smaller the increase in the supply of loanable funds, the smaller the changes in loanable funds, the real interest rate, and investment