The Loanable Funds theory

We use the term “loanable

funds market” to describe the
arrangements and institutions
by which saving of households
is made available to borrowers.
 Fa
ct or
in co
1. Leakages must be recycled me
if total spending is to
match full-employment
GDP.

n
io
2. According to the Classical

pt
m
theory, the loanable funds

Ne
su

Saving
n
Co

tt
market acts as a conduit to

a xe
transfer spending power

s
(S) from households to
borrowing units (firms and
government units).
3. Saving (S) is the “source”
of loanable funds.
1. To have a more secure future, to start a
business, to finance a child’s education,
to satisfy miserliness, . . .
2. To earn interest.
We view interest as
the “reward for
saving” or the
“reward for
postponing
gratification.”
 The opportunity cost
of spending now
Value of $1,000 in 3 years at (measured in lost
alternative interest rates future spending) is
positively related to
Interest rate Future value the interest rate.
4% $1,127.27
5% $1,161.47
6% $1,196.68
7% $1,232.93
8% $1,270.24
9% $1,308.65
10% $1,348.18
11% $1,388.88
12% $1,430.77
 Supply of Funds
Saving = Supply
of Funds
Interest rate

5%

3%

0 1.5 1.75 Trillions of

Dollars
•To finance the acquisition of long-lived capital goods.
•The rate of interest is the cost of borrowing or the price of
loanable funds.
•The investment demand curve indicates the level of
investment spending at various interest rates.
•As the interest rate decreases, more investment projects
become attractive in the assessment of business decision-
makers—hence, the investment demand function is
downward-sloping with respect to the interest rate.
Demand for Funds
by Business When the interest rate
falls, investment
spending and the
business borrowing
Interest rate

needed to finance it
A rises.
5%
B
3%
Investment
Demand

0 1.5
1.0 Trillions of
Dollars
Public sector borrowing

•Let G denote public sector (or government)

spending for goods and services in a year
•T is net tax receipts in a year.
•If G is greater than T, the the public sector
has a budget deficit equal to G – T.
•If T is greater than G, then the public sector
has a surplus equal to T – G.
•If the public sector has a budget deficit, it
must borrow.
 Public Sector Borrowing in Classica
G = $2 trillion
T = $1.25 trillion
Therefore,
Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion
Government
Demand for
Funds
Interest Rate

5% B

3% A

0 0.75 Trillions of Dollars

 Demand for Loanable Funds (in Trillions)

[1 ] [2 ] [3 ] = [1 ] + [2 ]
In te r e s t R aBteu s i n e s s D e mG ao nv ed r n m e n t D eTmo ta
a nl dD e m a n d
5% 1 .0 0 .7 5 1 .7 5
3% 1 .5 0 .7 5 2 .2 5
 Total
Demand for
Funds
Interest Rate

5%

3%

0 1.75 2.25 Trillions of Dollars

 Loanable Funds Market Equilibrium

Total Supply of
Funds (Saving)
Interest Rate

5% E

Total Demand
for Funds
(Investment +
Deficit)
0 1.75 Trillions of Dollars
Why does the loanable funds theory
guarantee the validity of Say’s law?

S = IP + G - T

Quantity of Quantity of
Funds Funds
Supplied Demanded
Now, rearrange the equation above by bringing T
to the left side:

S + T = IP + G

Injections
Leakages
So long as the loanable funds
market “clears,” leakages
(Saving) will be offset to
injections (investment and
government spending).
 Income
Income
($7($7
Trillion)
Trillion)

Consumpt
ion Saving ($1.75
Households
($4 Trillion)
Trillion) Net Taxes Loanable Funds
($1.25 Markets
Governme Trillion)
Deficit
nt
($0.75
Spending
Government Trillion
($2
Goods Trillion)
Resource
Markets Markets
Investmen
Firm t
Revenues ($1
($7 Trillion) Trillion)
Firms Factor
Payments
($7 Trillion)
 Changes in government spending, transfer
payments, and taxes designed to change
total spending in the economy and thereby
influence total output and employment.
The Classical view of Fiscal policy

Friends, we believe that

fiscal policy is
unnecessary and
ineffective. The economy
is doing just fine without
meddling by
Washington.
•Crowding out is the idea that an increase in
one component of spending will cause a
decrease in other spending components.
•An increase in G may cause a decrease in C,
IP, or both—that is, government spending may
“crowd out” private spending.
 Crowding Out With an Initial Budget Deficit
Total Supply of
Funds (Saving)
7 B •Increase in G
%
= AH
A C •Decrease in C
H
Interest Rate

5% = AC
•Decrease in IP
= CH
D2 = IP +
G2 - T
D1 = IP +
G1 - T
0 1.75 2.05 2.25 Trillions of Dollars
Effects of a Reduction in the Government Surplus

S2 = Savings +
T – G2 S = Savings +
1
T – G1
Interest Rate

7% B
H C A
5%

D = Investment

0 1.25 1.55 1.75 Trillions of Dollars