FS - Banks and the Money Supply (Lesson)

Banks and the Money Supply

Introduction

The loanable funds market is made up of borrowers, who demand funds, and lenders, who supply funds. The loanable funds market determines the real interest rate. Four groups demand and supply loanable funds:

1. consumers
2. government
3. foreigners
4. businesses

The same four groups demand and supply loanable funds, so it is important to understand the economic behavior depicted by the demand and supply curves for loanable funds.

 

The Loanable Funds Market

The loanable funds market is made up of borrowers, who demand funds, and lenders, who supply funds. The loanable funds market determines the real interest rate. Four groups demand and supply loanable funds: consumers, the government, foreigners, and businesses. The same four groups demand and supply loanable funds, so it is important to understand the economic behavior depicted by the demand and supply curves for loanable funds.

 

Where does REAL Interest Rate come from?

The demand curve for loanable funds is negatively sloped.

More loans are demanded at lower real interest rates, and fewer loans are demanded when real interest rates are higher. Businesses, for example, will find more projects worthwhile to invest in at lower rates than at higher rates. Profits rise as interest rates fall. Businesses will therefore borrow more at lower rates to finance the increased business investment spending. Consumer and foreigner borrowing is also sensitive to changes in the interest rate. Consider that the monthly payments for a mortgage are higher with a higher real interest rate. As the rate rises, fewer consumers can afford the higher mortgage payments. Government borrowing is not very sensitive to the interest rate.

The upward slope of the supply of the loanable funds demonstrated the willingness of households to save.

The opportunity cost of saving is spending now. The more income saved, the less can be spent now. The opportunity cost rises as more and more income is saved. Thus, higher rates of interest are needed to compensate for the increasing opportunity cost of saving.

The equilibrium real interest rate is the rate at which the total amount savers are willing to lend equals the total amount borrowers are willing to borrow. The major determinants of the demand for loanable funds are business confidence and expectations, consumer confidence and expectations, government budget plans, and income levels.

Watch the video to review loanable funds before moving forward.

 

 

Now let's look at some examples:

Remember:

The D curve represents the borrowers... the ones demanding funds.

The demand curve is a NEGATIVE slope.

What would make the D Curve shift RIGHT?

• For example, if businesses are confident of future profits, they will want to borrow more at all possible real interest rates to expand operations, and the D curve shifts to the right.
• Rising incomes would cause consumers to borrow more since their higher incomes enable them to pay back higher amounts.
• The lower the interest rate, the more capital firms will demand.
• The more capital that firms demand, the greater the funding that is required to finance it.

 

 

 

What would make the D Curve shift LEFT?

• If the government decreases spending to reduce the deficit it decreases the need to borrow, and the D curve shifts to the left.
• If consumers become concerned that the economy is heading toward a recession, they will become concerned about their ability to repay loans and will cut back on their borrowing, decreasing the demand for loanable funds.
•  A decrease in demand creates a shift to the LEFT.

To sum it up: The lower the interest rate, the greater the amount of capital that firms will want to acquire and hold, since lower interest rates translate into more capital with positive net present values. The desire for more capital means, in turn, a desire for more loanable funds. Similarly, at higher interest rates, less capital will be demanded, because more of the capital in question will have negative net present values. Higher interest rates therefore mean less funding demanded.

 

Now lets look at examples from the supply side.

Remember: The S curve represents the suppliers, the ones supplying the funds.

The supply curve is a POSITIVE SLOPE.

On the supply side, if the government reduces the income tax rate on interest income, consumers will want to save more at every real interest rate, and the S curve will shift to the right.

Anything that causes consumers to save more will shift the S curve to the right.

The Federal Reserve plays a significant role on the supply side of the loanable funds market.

A good way to view the loanable funds market is to consider the bond market with an understanding that bonds are fixed-rate loans. Thus, anyone who buys a newly issued bond is loaning funds to the seller of the bond. The demand for loanable funds then is the same as the supply of bonds in the bond market, and the supply of loanable funds is the same as the demand for bonds in the bond market. Considering these relationships helps to understand that bond prices and interest rates are inversely related.

• For example, an increase in demand for loanable funds (increase in supply of bonds) raises interest rates in the loanable funds market (and decreases bond prices in the bond market).

 

When a firm decides to expand its capital stock, it can finance its purchase of capital in several ways. It might already have the funds on hand. It can also raise funds by selling shares of stock, as we discussed in a previous module. When a firm sells stock, it is selling shares of ownership of the firm. It can borrow the funds for the capital from a bank. Another option is to issue and sell its own bonds. A bond is a promise to pay back a certain amount at a certain time. When a firm borrows from a bank or sells bonds, of course, it accepts a liability—it must make interest payments to the bank or the owners of its bonds as they come due.

Regardless of the method of financing chosen, a critical factor in the firm’s decision on whether to acquire and hold capital and on how to finance the capital is the interest rate. The role of the interest rate is obvious when the firm issues its own bonds or borrows from a bank. But even when the firm uses its own funds to purchase the capital, it is foregoing the option of lending those funds directly to other firms by buying their bonds or indirectly by putting the funds in bank accounts, thereby allowing the banks to lend the funds. The interest rate gives the opportunity cost of using funds to acquire capital rather than putting the funds to the best alternative use available to the firm.

The interest rate is determined in a market in the same way that the price of potatoes is determined in a market: by the forces of demand and supply. The market in which borrowers (demanders of funds) and lenders (suppliers of funds) meet is the loanable funds market.

Watch the presentation below to learn more about the loanable funds market.

 

 

Review

Review what you have learned by completing the activity below.

 

In Summary . . .

• The demand curve for capital shows that firms demand a greater quantity of capital at lower interest rates. Among the forces that can shift the demand curve for capital are changes in expectations, changes in technology, changes in the demands for goods and services, changes in relative factor prices, and changes in tax policy.
• The interest rate is determined in the market for loanable funds. The demand curve for loanable funds has a negative slope; the supply curve has a positive slope.
• Changes in the demand for capital affect the loanable funds market, and changes in the loanable funds market affect the quantity of capital demanded.

 

 

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