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##### The Loanable Funds theory

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**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.**Factor income**• Leakages must be recycled if total spending is to match full-employment GDP. • According to the Classical theory, the loanable funds market acts as a conduit to transfer spending power (S) from households to borrowing units (firms and government units). • Saving (S) is the “source” of loanable funds. Consumption Net taxes Saving**Why do households save?**? • To have a more secure future, to start a business, to finance a child’s education, to satisfy miserliness, . . . • To earn interest. We view interest as the “reward for saving” or the “reward for postponing gratification.”**The opportunity cost of spending now (measured in lost**future spending) is positively related to the interest rate. Value of $1,000 in 3 years at alternative interest rates**Supply of Funds**Saving = Supply of Funds Interest rate 5% 3% 0 1.5 1.75 Trillions of Dollars**Why do firms borrow?**• 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 needed to finance it rises. Interest rate A 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.**Federal Government Budget Surplus (Deficit) in billions ,**1955-2000 www.economagic.com**Public Sector Borrowing in Classica**G = $2 trillionT = $1.25 trillionTherefore, Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion Government Demand for Funds 5% B Interest Rate 3% A 0 0.75 Trillions of Dollars**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 Funds Supplied Quantity of Funds 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 ($7 Trillion)**Income ($7 Trillion) Households Consumption ($4 Trillion) Saving ($1.75 Trillion) Loanable Funds Markets Net Taxes ($1.25 Trillion) Government Spending ($2 Trillion) Deficit ($0.75 Trillion Government Resource Markets GoodsMarkets Investment ($1 Trillion) Firm Revenues ($7 Trillion) Firms Factor Payments ($7 Trillion)**Fiscal Policy**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**• 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) B • Increase in G = AH • Decrease in C = AC • Decrease in IP = CH 7% A C Interest Rate H 5% 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 S1 = Savings + T – G1 Interest Rate B 7% H C A 5% D = Investment 0 1.25 1.55 1.75 Trillions of Dollars