InvestmentIntroduction to the Loanable Funds Market

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

GDP

Investment

Autonomous Investment

Id

InterestRate

$ Investment

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

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

National, Private & Public

• National Saving– Income that remains after paying for C + G – Equals Y – 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)

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

Loanable Funds

Loanable Funds(in billions of dollars)

0

RealInterestRate

Supply

Demand

5%

$1,200

Sum of Public& PrivateSavings

InvestmentDemand

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

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

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

Changing Saving Incentives

Loanable Funds(in billions of dollars)

0

RealInterestRate

Supply, S1 S2

2. . . . whichreduces theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

Tax incentives forsaving increase thesupply of loanablefunds . . .

5%

$1,200

4%

$1,600

Example: Investing Incentives• A tax credit on investing

– will increase the incentive to invest:

RealInterestRate

Qty Loanable Funds

D1

S1

---------------------------

i1

Q1

E1

D2

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Demand IncreasesInterest Rates rise

Worksheet