Loanable Funds Market

The Loanable Funds Market

•The market where savers and borrowers exchange funds (QLF) at the real rate of interest. 

•The demand for Loanable funds, or borrowing comes from households, firms, government, and the foreign sector. The demand for Loanable funds is in fact the supply of bonds. 

•The supply Loanable funds, or savings comes from households, firms, government, and the foreign sector. The supply of Loanable funds is also the demand for bonds. 

-Changes in the demand for Loanable funds

•Remember that demand for Loanable funds= to borrowing or supplying of bonds 

•More borrowing= more demand Loanable funds 

•Less borrowing= less demand for Loanable funds 

•Examples

- Government deficit spending= more borrowing = more demand for Loanable funds 

DLF-> r%

-Less investment demand= less borrowing= less demand for Loanable funds 

Changes in the supply of Loanable funds

•remember that supply of Loanable funds= saving (demand for bonds)

•More saving= more supply of Loanable funds 

•Less saving= less supply of Loanable funds

EXAMPLES 

-Government budget surplus= more saving = more supply of Loanable funds 

-Decrease in consumers MPS= less saving= less supply of Loanable funds 

*When the government does fiscal policy it will affect the Loanable funds market*

*Changes in the real interest rate will affect Gross Private Investment* 

Federal Fund Rate

Federal Fund Rate

• it is the interest rate that commercial banks charge other commercial banks for over night loans.

PRIME rate 

• it is the interest rate that is given to a banks most credit worthy customers 

Anywhere from 0 to 4 % 

AP Macroeconomics Unit 4 Video Series Notes

Part 1:
There are three types of money. The types of money she brings up are commodity money, which has been around and has been used the longest. Then there is representative money which means whatever you are using as currency is representing a specific quantity of metal. And lastly, the type of money we use today, Fiat money. This money is not back by precious metal and must be accepted for transactions. The functions of money consist of is that money is a medium of exchange, money as a store of value, and lastly, money being a unit of account.

Part 3:
Money Market graphs are graphs that we have to become very familiar with and have to be able to master them when it comes to drawing them properly. The Y Axis will always be labeled as the interest rate, and the x axis will be labeled as the quantity of money. The demand for money will slope in a downward direction because when the price is high, demand is low and vise versa. What is different from the supply and demand graphs is that the supply of money is vertical in this case. Demand for money is set by the Fed.

Part 4:
Expansionary policies are also called easy money, and contractionary policies are called tight money. Required reserves is a portion of money that is of the total deposits that they have to hold on to. Money that has been RR will become the excess reserves that the bank can begin to loan out. The discount rate is the rate that banks can borrow money from the fed. This is the interest rate that the fed charges.

Part 7:
Another graph we have to learn to  master is the loanable funds graph. We have to tie it to the money market and show the results in AD/AS graphs. Loanable funds is money that is available for the public to borrow. Demand for loanable funds is downward sloping, while the supply slopes in an upward direction. Supply of loanable funds is dependent on people's savings.

Part 8:
Another concept we have to become familiar with is the money creation process. Banks create money by creating loans, which is a key point in the process of creation. One of the Feds tools is being able to adjust and control the Reserve Requirement. The formula for the money multiplier is 1/RR.

Part 9:
We have to learn how to show the connection of what is actually happening in the economy. Keep everything labeled to show your work. To be consistent, show the same interest rate and the demand will slope downward. Increase in government spending is going to increase aggregate demand. Do not try to change 5 or 6 factors at once because it will get very complicated.

•Demand for money has an inverse relationship between nominal interest rates and he quantity of money demanded. 

1. What happens to the quantity demanded of money when interest rates increase? QD decreases. 

2. What happens when to the quantity demanded when interest rates decrease? QD increases. 

Seven Functions of the FED

*Multiple Deposit Expansion and the Federal Reserve*

•Seven Functions of the FED

1) issue paper currency: paper currency produced everyday

2) sets reserve requirements and holds reserves of banks

3) it lends money to banks and charges them interest

4) they are a check clearing service for banks

5) it acts as personal bank for the government 

6) supervises member banks

7) controls the money supply in the economy 

 

•Investment: redirecting resources that you would consume now for the future. 

•Financial Assets: Claims on property and income of the borrower 

•Financial Intermediaries: An institution that channels funds from savers to borrowers.

•Three purposes for Financial Intermediaries 

-Share risk (diversification is the number one way risk is shared) which means spreading out your investment to reduce risk. 

-Providing information

- Liquidity: easily converted to cash 

      -(Returns: it is the money an investor receives above and beyond the sum of money that was initially invested)

     -*Higher the risk, higher the investment* 

•Bonds: are loans or IOUs that represent death that 

-generally low risk investments

•3 components

    1) coupon rate: it is the interest rate that a bond issuer will pay to a bond holder. 

    2) Maturity: time at which payment to a bond holder is due. 

    3) Par Value: the amount that an investor pays to purchase a bond and that will be repaid to an investor at maturity. 

•Yield: the annual rate of return on a bond if the bond were held to maturity. 

•The difference between bonds and stocks are bonds you loan and stocks you own. 

•Time value of money 

•Is a dollar today worth more than a dollar tomorrow? 

    -YES 

•Why? 

     -Opportunity cost and inflation 

     -this is the reason for charging and paying interest.

Let V= future value of money 

      P= present value of money 

      R= real interest rate( nominal rate- inflation rate)  expressed as a decimal 

      N= years

       K= number of times interest is credited per year 

• The simple interest formula 

   - v= (1+r)^n •p 

•The compound interest formula

    - v = (1+ r/k)^nk•p

•Monetary Equation of Exchange 

•MV= PQ

-M= money supply (m1 or m2) 

-V= moneys velocity (m1 or m2) 

-P= price level (PL on the AS/AD diagram) 

-Q= real GDP (sometimes labeled y on the AS/AD diagram) 

Money Notes

•Money is any asset that can be easily used to purchase goods and services. 

•Three uses of money: 

- Medium of Exchange: it is used to determine value 

-Unit of Account: need something where you can compare the costs of items. 

-Store of Value: when you hide money

•Three types of money:

-Commoditie money: salt, olive oil, and gold

-representative money: represents something of value (IOU) 

-Fiat money: money because the government says so (paper currency and coins) 

•Six characteristics of money:

1) Durability: how long it lasts 

2) Portability: take it  and store wherever you go and want 

3) Divisibility: being able to be broken down 

4) Uniformity: all money looks the same 

5) Limited supply

6)Acceptability 

•Money Supply: all of the available money in the US economy 

•M1 Money: 

-Consists of liquid assets (liquid means easily converted to cash) 

    -Currency 

    - Coins

    - Checkable deposits (checks) 

    - Travelers checks 

•M2 Money: 

 - Consists of M1 money plus savings accounts plus money market accounts. 

•Three purposes for financial institutions:

-store money

-save money

-loan money 

•Two reasons to LOAN money: 

-Credit cards

-mortgage 

•Four ways to save money 

-through savings account

-through checking account 

-through money market account 

-through certificate of deposit (CD) 

•Loans: Banks operate on a fractional reserve banking system, which means they keep a fraction of the funds and loan out the rest.

•Two components of interest rate 

•Principal: the amount of money borrowed

Interest: price paid for the use money 

•Two types of interest: 

-Simple: 

-Compound: paid on the principle plus the accumulated interest 

•Formula for simple interest 

I= p•r•t / 100 (principal•rate of interest•time) 

T= i•100/ p•r 

P= i•100/ r•t

R= I•100/ p•t

•Types of Financial Institutions 

-commercial banks

-savings and loans institutions 

-mutual savings banks 

- credit unions 

-finance companies 

Fiscal Policy Notes

Fiscal policy (2/25)

Changes In expenditures or tax revenues of the federal government.

2 tools of fiscal policy 

•taxes- government can increase or decrease taxes

•spending- government can increase or decrease spending.

Deficits, surpluses, and debt

•balanced budget

-revenues=expenditures 

•budget deficit

-revenues < expenditures

•budget surplus

-revenues > expenditures 

•government debt

-sum of all deficits - sum of all surpluses

Government must borrow money when it runs a budget deficit

•individuals

•corporations

•financial institutions

•foreign entities or foreign governments 

Two options

•discretionary fiscal policy (action) 

-expansionary fiscal policy -think deficit

-contractionary fiscal policy -thing surplus 

•nondiscretionary fiscal policy (no action)

Discretionary 

•increasing or decreasing government spending and or taxes in order to return economy to full employment. Involves policy makers doing fiscal policy in response to an economic problem. 

Automatic

Unemployment compensation & marginal tax rates are examples that help mitigate the effects of recession and inflation. Takes place without policy makers having to respond to current economic problems.

Contractionary v. Expansionary fiscal policy

Contractionary- policy designed to decrease aggregate demand.

-strategy for controlling inflation

Expansionary- policy is designed to increase aggregate demand.

-strategy for increasing GDP, combatting a recession and reducing unemployment 

•increases government spending

•decreases taxes

Contractionary fiscal policy

•Decreases government spending 

•Increases taxes

Automatic or built in stabilizers

•anything that increases the government spending budget deficit during a recession and increases its budget and surplus without requiring explicit action by policy makers. 

•welfare checks

•food stamps

•unemployment checks

•corporate dividends 

•social security

•veteran's benefits 

Progressive tax system

•average tax rate (tax revenue/GDP) rises with GDP

Proportional tax system 

•average tax rates remains constant as GDP changes

Regressive tax systems

•average tax rate falls with GDP

Disposable Income Notes

Disposable income (DI)

Income after taxes or net income

DI= Gross Income - taxes

2 choices

With disposable income, households can either 

-Consume (spend money on goods and services)

-Save (not spend money on goods and services)

Consumption 

Household spending

The ability to consume is constrained by

-the amount of disposable income

-the propensity to save

Do households consume if DI=0?

-Autonomous consumption 

-Dissaving

APC=C/DI=% DI that is spent 

SAVING

Household NOT spending

The ability to save is constrained by 

-the amount of disposable income

The propensity to consume

Do households save if DI=0?

-NO

APS= S/ DI= % DI that is not spent 

APC& APS

APC+APS=1

1-APC= APS

1-APS= APC

APC> 1.: Dissaving 

-APS.: Dissaving 

Marginal propensity to Consume

-CHANGE IN C/CHANGE IN DI

-% of every extra dollar earned that is spent 

Marginal propensity to Save 

-CHANGE IN s/CHANGE IN DI

-% of every extra dollar earned that is saved

Mpc+mps=1

1-mpc=mps

The spending multiplier effect 

An initial change in spending causes a larger change in aggregate spending or aggregate demand

Multiplier= Change in AD/ Change in spending

Multiplier = change in AD: change in c,i, g, Xn

Why does this happen?

Expenditures and income flow continuously which sets odds spending increase in the economy. 

The spending multiplier cans be calculated from the mpc of the mps 

Multiplier = 1/1-MPC or 1/MPS

Multipliers are positive when there is an increase in spending and negative when there is a decrease 

Small changes in expenditure are examined by the multiplier effect.

When the government taxes the multiplier works in reverse 

Why?

Because now money is leaving the circular flow

Tax multiplier (it's negative)

•=-MPC/1-MPC or -MPC/ MPS 

If there is a tax cut, then the multiplier is positive because there is now more money in the circular flow 

LRAS: Represents a point on economy's production possibility curve. 

-always vertical 

-always stable at full employment 

LRAS DOESNT CHANGE AS PRICE LEVEL CHANGES

Only things that can shift LRAS 

Change in technology 

Change in economic growth 

Change in resources 

Interest Rates and Investment

What is investment? 

•It is money spent or expenditures on: 

New plants (factories)

Capital equipment (machinery)

Technology (hardware and software)

New homes 

Inventories(goods sold by producers) 

Expected rates of return 

How does business make investment decisions?

Cost and benefit analysis

How does business determine the benefits

-Expected rate of return 

How does business count the cost?

Interest cost

How does business determine the ending is investment they undertake?

Compare expected rate of return to interest cost

•If expected return> interest cost, then invest

•If expected return< interest cost m, then do  invest 

Real VS nominal 

What's the difference?

Nominal is the observable rate of interest. Real subtracts out inflation and is only known ex post facto. 

How do you compute the real interest rate?

R%= i% - inflation 

What then determines the cost of an investment decision?

The real interest rate (r%)

What is the shape of the investment demand curve? 

-Downward sloping 

Why?

-When interest rates are high, fewer investments are profitable when interest rates are low, more investments are profitable. 

Shifts in investment demand 

Cost of production 

Lower costs shift ID➡️

Higher cost in production <

Business taxes 

Lower business taxes shift ID➡️

Higher business taxes shift ID<

Technological change

New technology shifts ID➡️

Lack of technological change shift ID<

Stock of Capital 

If an economy is low in capital then ID➡️

If an economy has much capital then ID<

Expectations

Positive expectations ➡️

Negative<

Employment Notes

Full employment

• Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point. 

Recessionary Gap

• A recessionary gap exits when equilibrium occurs below full employment output.

Inflationary Gap

• An inflationary gap exists when equilibrium occurs beyond full employment output. 

Aggregate Supply Notes

•The level of real GDP that firms will produce at each price level.

•REAL GDP is measuring what output is. 

•Long run: a period of time where input prices are completely flexible and adjust to changes in the price level

-in the long run the level of real GDP supplied is independent of the price level

•Short run: period of time where the input prices are sticky and do not adjust to changes in the price level

-in the short run, the level of real GDP supplied is directly related to the price level. 

•Long run aggregate supply (LRAS)

•The long run aggregate supply marks the level of full employment in the economy (analogous to ppc)

•Because the input prices are completely flexible in the long run, changes in price level do not change firms real profits and therefore do not change firms level of output. This means that LRAS is vertical at the economies level of full employment. 

•Short Run Aggregate Supply 

•Because input prices are sticky in the short run, the SRAS is upward sloping. 

•Changes in SRAS

• An increase in SRAS is seen as a shift to the right. 

•A decrease in SRAS is seen as a shift to the left. 

•The key to understanding shifts in SRAS is per unit cost of production 

•Per unit cost= Total output cost/total input

•Per  

•Determinants of SRAS (all affect unit production cost)

-input prices

-productivity 

-legal institutional environment 

•Input Prices

Domestic resource prices 

-wages (75% of all business costs) 

-cost of capital 

-raw materials (commodity prices)

Foreign resource prices

-Strong $; lower foreign resources prices

-Weak $: higher foreign resource prices 

Marker power 

-Monopolies and cartels that control resources control the price of those resources 

•Increases in Resource Prices= SRAS<

•Decreases in Resource Prices= SRAS➡️

Productivity 

•Productivity= total output/total inputs

•More productivity= lower unit production cost= SRAS➡️

•Lower Productivity= higher unit production cost= SRAS<

Legal institution environment

Taxes and subsidies 

-taxes ( $ to government on business increase per unit production cost = SRAS<

-Subsidies ($ to government) to business reduce per unit production cost = SRAS➡️

Government regulation

-Government regulation creates a cost of compliance= SRAS <

-Deregulation reduces compliance costs= SRAS ➡️

Aggregate Demand Notes

-Aggregate(TOTAL) Demand (AD)

•Shows the amount of real GDP that the private, public and foreign sector collectively desire to purchase price level

•The relationship between the price level and the level of REAL GDP is inverse 

-Three reasons AD is downward sloping

•Real Balances Effect

- When the price level is high households and businesses cannot afford to purchase as much output 

- When the price level is low households and businesses can afford to purchase more output

• Interest Rate Effect 

- A higher price level increases the interest rate which tends to discourage investment 

- A lower price level decreases the interest rate which tends to encourage investment 

•Foreign Purchase Effect

- A higher price level increases the demand for relatively cheaper imports

- A Lower price level increases il the foreign demand for relatively cheaper US exports 

•Shifts in Aggregate Demand

• There are two parts to a shift in AD

- a change in C, Ig, G, and/or Xn (expenditure approach to GDP)

- a multiplier effect that produces a greater change than the original change in the 4 components

•increases in AD= AD➡️

•decreases in AD=⬅️

•Consumption 

•Household spending is affected by:

 - consumer wealth 

       •more wealth= more spending(AD shift➡️)

       •less wealth= less spending(AD⬅️)

-Consumer expectations 

     •positive expectations=more spending(AD➡️)

•  negative expectations=less spending(AD⬅️)

-Household indebtedness 

   •less debt=more spending(AD➡️)

   •more debt= less spending(AD⬅️) 

-Taxes

     •less taxes=more spending(AD➡️)

      •more Taxes=less spending⬅️

GROSS DOMESTIC Private investment 

•investment spending is sensitive to

    -the Real Interest Rate 

      •lower real interest rate= more investment 

       •higher real interest= less investment 

-Expected Returns

  •higher expected returns: more investment 

  •lower expected returns: less investment 

  • expected returns are influenced by:

       -expectations of future profitability 

       -technology 

       -degree of excess capacity (existing stock of capital) 

•Government Spending 

 - more government spending shift right 

 -less government spending AD shift left

•Net Exports

   •net exports are sensitive to:

       -Exchange Rates(international value of $)

          •strong $= more imports and fewer exports= AD ⬅️

          •weak $= fewer imports and more exports= (AD➡️)

         -Relative Income

            •Strong Foreign Economies= More exports AD➡️

             •Weak foreign economies= less exports AD(⬅️)