PDF Loanable Funds and Financial Markets

Loanable Funds and Financial Markets

This is the chapter where we study financial markets. We start with a general theoretical look at the market for loanable funds. Here we talk about all the factors that influence supply and demand for loanable funds. We then bring it together to discuss why interest rates fluctuate and the importance of savings to the macroeconomy. After that, we turn to different types of financial securities, like stocks and bonds.

The financial industry is a special in macroeconomics. GDP depends on the tools, workers, and other resources used to produce goods and services ? and much of these are paid for through funds loaned to the firm. Loanable funds are people's savings that firms turn into investment. The market for these loanable funds is the centerpiece of this chapter.

Efficient loanable funds markets fuel economic growth. But trouble in this market ripples throughout the entire economy and often spreads around the globe. The recession of 2008 is a prime example. The worst U.S. economic downturn in nearly 30 years started with trouble in financial markets in 2007. By the end of this chapter, we'll explain many of the little pieces that led to instability in financial markets and spread the problems around the world.

The 2008-2009 recession started with trouble in the U.S. loanable funds market. The financial problems spread throughout the world and led to millions of job losses in the U.S.

In this chapter, we discuss many of the same topics you might study in a course on banking or financial institutions, but our emphasis is certainly different. We are interested in studying how financial institutions and markets affect the macroeconomy. For example, we'll talk about stock markets, but we don't discuss dividends or the different types of stock offerings a firm may have. We will emphasize the importance of stock shares as a tool for channeling investment funds to firms for expansion and growth.

Learning Objectives

To understand the role of the loanable funds market. To understand why interest rates rise and fall. To understand basic financial securities.

 To understand the role of secondary security markets.

[A] The Loanable Funds Market

The center of financial markets is what economists call the loanable funds market. This is where borrowers from all over the economy come to get funds and savers come to lend. It is not a single physical location, but includes places like stock exchanges, investment banks, mutual fund firms and the commercial banks where we all have accounts.

Figure 23.1 illustrates the role of the loanable funds market. Savings flows in and this is translated into loans for borrowers. We could call it the market for savings, or even the market for loans. The term "loanable funds" captures the information in both: peoples' savings are funds available for loans to borrowers, or loanable funds.

On the left side, the suppliers of funds (savers) include households, and foreign entities. These foreign entities include both the private citizens and governments that decide to save in the United States. For most of our applications, it helps us to focus on households (private individuals/families) as the primary suppliers of loanable funds. If you have a checking or savings account at a bank, you are a supplier of loanable funds. Household savings in retirement accounts, stocks, bonds, and mutual funds are other big sources of loanable funds. Going forward, with few exceptions, we'll focus on households as the suppliers of loanable funds.

Figure 23.1 The Loanable Funds Market is the Center of all Saving and Borrowing

Savers

Households Foreign Entities

Savings

$$$

Loanable Funds Market

Banks Bonds Stocks

Loans

$$$

Borrowers

Firms Governments

The demanders of loanable funds include business firms, and governments. We'll cover government borrowing in Chapters 29 and 30. For now, we focus on firms as the primary borrowers of loanable funds.

To reinforce the importance of this market, think about why borrowing takes place. The key reason is firms' borrow to invest. That is, firms, looking to produce output in the future, must borrow to pay expenses today. Recall the production timeline we introduced in Chapter 22, it is reproduced below as Figure 23.2. Production depends on spending today for resources. This spending comes before any revenue from the sale of output. Therefore, firms must borrow. If firms are to produce output (GDP) in the future they need to borrow today. That's how important the loanable funds market is.

Figure 23.2: The Production Timeline

Prepare to Produce

-Borrow $$ -Build Capital Goods -Hire Workers

Production

Sell Output (GDP)

-Repay Loans $$

Today

Future Periods

Time

Consider a simple example. You want to produce and sell college gear. If you do this, GDP goes up. But before you ever sell your first shirt, hat, or sweatpants, you have to spend on your inputs or factors of production. For example, if you plan on silk-screening your college logo onto

hooded sweatshirts, you have to buy sweatshirts, paint, and a screen printing press. Since you have no revenue, you go to the loanable funds market and borrow to pay for these investments.

Let's be clear about this: without the loanable funds market, future GDP dries up. The financial industry is not like every other industry in an economy. When there is trouble in the loanable funds market, that trouble spreads across industries and nations ? that's why it is often referred to as "contagion."

Before you can sell your college hoodies, you have to buy equipment and other supplies. Normally, firms pay for these expenses by borrowing in the loanable funds market.

Borrowing fuels investment which creates future output. But every dollar borrowed requires a dollar saved. Without savings, we cannot sustain future production ? savings is that important. If you want to borrow to buy your resources to produce college apparel, somebody has to save.

Working backwards, the chain of crucial relationships looks like this:

Output (GDP) requires investment. Investment requires borrowing. Borrowing requires savings. And all of this requires a loanable funds market that efficiently channels savers' funds to borrowers.

It's helpful to think of the loanable funds market in terms of prices, quantities, supply and demand - like any other market. The good in this market is loanable funds. Demanders are borrowers, and suppliers are savers. Figure 23.* summarizes the distinctions of the loanable funds market.

This approach helps simplifies a potentially confusing discussion of interest rates because an

interest rate is just a price. An interest rate is the price of loanable funds. It is like the price of toothpaste, computers and hoodies; it is simply quoted differently. Many people, thinking about retirement, buying a house or car or some other big purchase, worry and fret over interest rate fluctuations and have no clear picture as to why interest rates rise and fall. The interest rate is just the price of loanable

Interest rate ? The price of loanable funds.

For savers, this is the reward for saving; for borrowers, it is the cost of borrowing.

funds, and if you know how to use supply and demand, you can determine what

makes interest rates rise and fall.

Figure 23.* Loanable Funds Market

Good

Loanable Funds

Price

Interest Rate

Sellers/Suppliers Savers

Buyers/Demanders Borrowers

Before delving into the loanable funds market, we should caution you about the use of this model. Like any model, it's a simplified version of reality. For example, initially we consider only one interest rate. For now, it can help to think of this as the general level of interest rates. But even with simplifying assumptions, the basic loanable funds model helps us understand much about real world financial issues.

[B] Supply of Loanable Funds

Recall that we generally think about the supply of savings as coming from households. This is an unusual market for students because it is the rare market where many of you are suppliers. If you have a positive balance in either a savings or checking account (as a college student, you may not have much), you are a supplier in the loanable funds market. This helps you relate to the supply side of this market. We turn now to several factors that affect the supply side of the loanable funds market.

[C] Interest Rates

Picture of Bank

If you are a saver, the interest rate is the return you get for supplying funds. For example, let's say your parents

lobby sign with

stocked you with some funds when you came to college. After buying some textbooks, supplies and basic

various interest rates

necessities, you have $500 left. So you consider saving this $500. You go to a bank near your campus and inquire about a new account. In this transaction, the bank is the buyer, and they offer certain prices they are

Banks are willing to pay you for your willing to pay for your savings.

savings. The price they pay is the interest rate.

When they do offer prices, they are not in dollars, as we are used to. They quote price in interest rates, or as a

percentage of how much you save. But it is really the same thing. So if you are saving $500,

they might tell you: "We'll give you 6% if you save that money for a year." But this is

equivalent to: "we'll give you $30 if you save that money for a year."

For savers, the interest rate is a reward. Every dollar saved today returns more in the future. The higher the interest rate, the greater the returns in the future. Table 23.* illustrates how interest rates affect $500 worth of savings. Let's say your bank is offering you 6% interest on your savings account. If you save $500 for one year, this brings you $530 next year, which is computed as:

$500 + 6% of $500 = $500 + 0.06*$500 = $500 + $30 = $530.

The higher the interest rate, the greater the incentive to save. If you can find a bank that pays you 10% interest, you could have $550 after just one year of saving. Higher interest rates induce more savings, as people respond to these incentives. This is the loanable funds version of the law of supply: the quantity of savings rises when the interest rate rises.

Incentives

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