Investment and Loanable Funds Market Dynamics

1. Investment Introduction to the Loanable Funds Market

2. Investment Interest Rate Autonomous Investment Id $ Investment GDP Investment • Investment (I) is a volatile component of GDP • Changes with level of interest rates • Investment has 3 subcomponents: • New capital expenditure by firms • New housing expenditure by households • Net inventories Includes: Firm builds new plants Orders more machines/supplies Raises/lowers inventories Investment is fixed At a given level of interest rate

3. Deriving Savings • GDP is both total income & total expenditure: Y = C + I + G + NX • Assume a closed economy – (does not engage in foreign trade) Y = C + I + G • Subtract C & G from both sides: Y – C – G = I

4. Derived Savings continued.. • New Equation: Y – C – G = I • This equals total income after paying for C & G • Y – C – G is known as Savings (S) (what you don’t spend, you save) • the equation can be written as: S = I • For the economy as a whole, savings must equal investment: {---------------} Savings = Investment

5. National, Private & Public • National Saving • Income that remains after paying for C + G • EqualsY – C – G • Private Saving • Income that households have left after taxes & consumption • Equals Y – T – C (T=Taxes) • Public Saving • Amount of tax revenue government has left after spending • Equals T – G (T=Taxes)

6. LOANABLE FUNDS • Financial markets coordinate the economy’s saving & investment in the market for loanable funds • Supply of loanable funds: • Sum of private & public savings • Demand for loanable funds: • households or firms that wish to invest

7. Supply Sum of Public & Private Savings 5% Demand Investment Demand $1,200 Loanable Funds Real Interest Rate Loanable Funds 0 (in billions of dollars)

8. Real Interest Rate • The price of the loan in real terms (r) • amount borrowers pay for loans & lenders receive on savings • If real return on investment is >r, then make investment

9. Government Policies • Gov’t Policies greatly affect Saving & Investment • Gov’t Incentives: • Taxes on savings • Taxes on investment • Size of Gov’t budget deficits or surplus

10. Example:Saving Incentives • A tax decrease on savings • Result: increases the incentive for households to save at any given interest rate • Supply of loanable funds curve shifts right • Equilibrium interest rate decreases • Quantity demanded for loanable funds increases

11. Supply, S1 S2 Tax incentives for 5% saving increase the supply of loanable 4% fund s . . . 2. . . . which Demand reduces the equilibrium interest rat e . . . $1,200 $1,600 3. . . . and raises the equilibrium quantity of loanable funds. Changing Saving Incentives Real Interest Rate Loanable Funds 0 (in billions of dollars)

12. Example:Investing Incentives • A tax credit on investing • will increase the incentive to invest: Demand Increases Interest Rates rise Real Interest Rate S1 ------------------ -------------- i1 E1 ------------------ D2 ------------- D1 Q1 Qty Loanable Funds

13. Worksheet