Econ 141 - Ch.

Notes on Chapter 4
Loanable Funds and the Real Interest Rate

— Potential GDP depends on the quantity of productive resources. The

growth rate of PGDP depends on how rapidly the resources grow.
— One of the major resources that is important to grow is the economy's
capital stock.
— The capital stock includes business capital as well as inventories.
— The economy's capital stock is measured by its total physical quantity
and quality of plants, machines, equipments, buildings, inventories of raw
materials and semi-finished goods, highways, schools, etc.
— In addition to the privately owned capital stock resulting from private
investment (business investment plus investment in new homes and
additions to inventories), we also have publicly owned capital stock in the
form of social infrastructure capital (highways, dams, schools).
— Social infrastructure capital is primarily created by government
investment.
— The capital stock is determined by investment decisions.
— The funds that finance investment are obtained in the market for loanable
funds.
— The market for loanable funds is the market in which households, firms,
governments, banks, and other financial institutions borrow and lend.
— To understand the investment and the saving decisions in the loanable
funds market, we have to understand the meaning of the interest rate and
distinguish between nominal interest rate and real interest rate. Classical

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 Econ 141 - Ch.4

theory treated saving as a direct function of the rate of interest and

investment as an inverse function

INTEREST RATE
— Interest rate is the price of fund (loan). It is the rate of interest charged
for the use of money, usually expressed as an annual percentage. The
rate is derived by dividing the amount of interest by the amount of money
borrowed.
— Example:
If a bank charged $50 a year to borrow $1,000, the interest rate would be
5%.
— The nominal interest rate (i) is the amount of money that a unit of
capital earns.
— It is the actual amount paid as interest per unit of currency borrowed for
each period.
— When people borrow money from a bank, the bank charges the nominal
interest rate. When you buy a car from a dealer and pay by installments,
the dealer charges you the nominal interest rate.
— Investment, saving and consumption all depend on real interest rate (r)
rather than nominal interest rate (i).
— The real interest rate (r) is the quantity of goods and services that a unit
of capital earns.
— It is nominal interest rate adjusted for inflation.
— The real interest rate (r) = nominal interest rate (i) - inflation rate
— Thus, the nominal interest rate = real interest rate (r) + inflation rate
— The real interest rate is the opportunity cost of loanable funds. It is the
opportunity cost of retained earnings.

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 Econ 141 - Ch.4

— Example:
o Suppose a bank has made a one-year loan of 1000 dinars with
nominal interest rate = 5%. At the end of the year, the bank would
receive 1050 (100 * 1.05). That is, the bank gained 5%. Suppose
the inflation rate of that year = 4%. The bank real gain or real
interest rate = 5% - 4% = 1%
— Exercise:
If real interest rate is 5 % and inflation rate is 4%. What would be the
nominal interest rate?

Uses and Resources of Loanable Funds

— Loanable funds are used in three purposes:
1. Business investment
2. Government budget deficit
3. International investment or lending
— Loanable funds come from three resources:
1. Private saving
2. Government budget surplus
3. International borrowing

The Demand for Loanable Funds

— The quantity of loanable fund demanded is the total quantity of funds
demanded to finance investment, the government budget deficit, and
international investment or lending during a given period.
— This quantity depends on
1. The real interest rate
2. The expected profit rate
3. Government and international factors

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 Econ 141 - Ch.4

— The demand for loanable funds is the relationship between the quantity
of loanable funds demanded and the real interest rate when all other
influences in borrowing plans remain the same.
— Business investment is the main component of loanable funds.
— Other things remaining the same, investment decreases if the real
interest rise (r) and increases if the real interest rate (r) fall.
— Equivalently, the quantity of real loanable funds demanded decreases if
the real interest rises and increases if the real interest rates fall. Thus, the
quantity of real loanable funds demanded, is negatively related to real
interest rate (r).
— From the above discussion, it should be clear that the demand for
loanable funds (DLF) curve is downward sloping, showing the negative
relationship between the real interest rate (r) and the quantity of loanable
funds demanded.
— A change in r results in a movement along the DLF curve.
o If r ↑, LF↓ and there is an upward movement along the DLF curve.
o If r ↓, LF↑ and there is a downward movement along the DLF
curve.
— Thus a change in the real interest rate brings a change in investment and
a change in the quantity of loanable funds demanded, which is shown by
a movement along loanable funds demand curve.
r (%)

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DLF1

DLF2 DLF0
LF
26 36
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 Econ 141 - Ch.4

— Exercise:
Consider the following table
Nominal
Inflation
Year interest
rate
rate
2001 8 4
2002 7.5 6
2003 9 7

a. Which year the country was expected to have the highest investment
in?
b. In 2001, the firm thought to invest $10000 in a project and the
expected annual revenue is $300. What is the expected net profit?
Should the firm do the project?
c. In 2003, the firm thought to invest $5000 in a project and the expected
annual revenue is $300. What is the expected net profit? Should the
firm do the project?

Changes in demand for loanable funds (Shifts of DLF curve)

— A change in any other influence on a firm’s decision to invest and borrow
funds is shown by a shift of a demand curve.
— These other influences are all the factors that affect a firm’s expected
profit.
— When the expected profit changes investment demand changes and
loanable funds change.
— Other things remaining the same, the greater the expected profit rate
from the new capital the greater is the amount of investment and the
greater is the demand for loanable funds; and the loanable funds demand
curve shifts rightward to DLF1.

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 Econ 141 - Ch.4

— When the expected profit decreases, investment demand decreases and

the loanable funds demand curve shifts leftward to ID2.
— The main factors that affect the expected profit rate are
1. Advances in technology: With the technological advances,
profits are expected to increase in the long run.
2. The phase of the business cycle: During expansion, an increase
in sales brings a higher profit rate; in recession, a decrease in
sales brings a lower profit rate.
3. Taxes: Changes in tax rates influence the firm's after-tax profit
rate.
— Changes in the expected profit rate appear to be more important than
changes in the real interest rate in contributing to changes in the
amount of investment in the economy (i.e., shifts in the loanable funds
demand curve are more important than movements along the curve).

The Supply of Loanable Funds

— The quantity of loanable funds supplied is the total funds available
from private saving, the government budget surplus, and international
borrowing during a given period. This quantity depends on
o The real interest rate
o Disposable income
o Wealth
o Expected future income
o Government and international factors

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 Econ 141 - Ch.4

The real interest rate and the quantity loanable funds supplied
(Movements along the Supply of loanable funds curve)
— The supply loanable funds (SLF) is the relationship between the
quantity loanable funds supplied and the real interest rate, other things
remaining the same.
— Saving is the main item that makes up the supply of loanable funds.
— There is a positive relationship between real interest rate and the quantity
of saving, and therefore there is a positive relationship between real
interest rate and quantity loanable funds supplied.
— Other things remaining the same, the higher the real interest rate the
greater is the saving; and the lower the real interest rate, the smaller is
the saving.
— Equivalently, the higher the real interest rate, the greater is the quantity
loanable funds supplied; and the lower the real interest rate, the smaller
is the quantity loanable funds supplied
— The supply of loanable funds curve (SLF) is upward sloping, showing
the positive relationship between the real interest rate and the quantity of
loanable funds supplied.
— A change in real interest rate results in a movement along the same SLF
curve, other things remaining the same.
— If r Ç Ö S ÇÖ upward movement along SLF curve.
— If r È Ö S ÈÖ downward movement along SLF curve.
— Saving increases when the real interest rate increases because r is the
opportunity cost of consumption.

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 Econ 141 - Ch.4

Changes in the Supply of Loanable Funds

(Shifts of the SLF curve):
r SLF2
— When any influence on saving other SLF0
than the real interest rate changes,
SLF1
saving supply changes and SLF curve shifts.
— The three main factors that influence
saving supply are:
— Disposable Income: An increase in
household’s disposable income ⇒ people
save more at each real interest rate ⇒ Loanable
Funds
an increase in SS and a shift of SLF
curve to the right
— Wealth: A household wealth equals its assets (what it owns) minus its
debt (what it owes). The purchasing power of household’s wealth is the
real value of its wealth. It is the quantity of goods and services that the
household’s wealth can buy.
— A decrease in wealth ⇒ people save more at each real interest rate ⇒ an
increase in SLF and a shift of SLF curve to the right
— Expected future income: A decrease in the expected future income ⇒
people save more at each real interest rate ⇒ an increase in SLF and a
shift of SLF curve to the right
— A decrease in disposable income, an increase in wealth, or an increase in
expected future disposable income decreases saving supply and shifts
the SLF curve leftward.

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 Econ 141 - Ch.4

EQUILIBRIUM IN FUND MARKET

(DETERMINATION OF THE REAL INTEREST RATE)
— As have been seen, other things remaining the
r
same, the quantities of loanable funds
SLF
demanded and supplied depends on the r1
real interest rate.
r*
— The higher the real interest rate, the greater
is the amount of saving and the larger is the
r2
quantity of loanable funds supplied, and DLF

the smaller is the amount of investment

Loanable
and the smaller is the quantitiy of loanable I* = S* funds
funds demanded.
— There is one interest rate at which the quantities of loanable funds
demanded and supplied are equal, and that is the equilibrium real interest
rate.
— The DLF curve and the SLF curve intersection determine the equilibrium
real interest rate (r*).
— The financial market is in equilibrium when the real interest rate is such
that the quantity of loanable funds supplied equals the quantity of
loanable funds demanded. There is neither a surplus nor a shortage of
saving so that investors can get the funds they demand and savers can
lend all the funds they have available.
— If r > r* ⇒ the amount of loanable funds supplied > the amount of
loanable funds demanded ⇒ surplus of funds available (surplus of loans)
⇒ lenders will be unable to find borrowers willing to borrow all of the
available funds and r ↓ to r* ⇒ the quantity of loanable fund demanded

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 Econ 141 - Ch.4

rises and the quantity of loanable funds supplied falls until the two are
brought into equilibrium.
— If r < r* ⇒ the quantity loanable funds supplied < the quantity loanable
funds demanded ⇒ shortage of the funds available (borrowers can't find
the loans they want, but lenders are able to lend all the funds they have
available) ⇒ r ↑ to r*
r
SLF
Changes in the Real Interest Rate
(Shifts in DLF and SLF)
r1
a. If any of the factors that influences r*

investment change, investment would

DLF1
change and DLF curve shifts. If firms ID0
expect higher net profit ⇒ DLF curve
I* = S* I1 S 1 LF
shifts rightward ⇒ r ↑ and the equilibrium
quantity of loanable funds ↑.

r
b. If any factor that affects saving changes,
SLF0
saving would change and SLF curve would
shift. If people's disposable income ↑ ⇒ SLF1

SLF curve shifts rightward ⇒ r ↓ and the r*

r1
the equilibrium quantity of loanable funds ↑.
DLF0

LF
I* = S* I1, S1

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 Econ 141 - Ch.4

c. If both I and S↑ ⇒ both DLF and SLF

r SLF0
curves shifts rightward ⇒ the amount
of loanable funds ↑ but r may ↑, ↓or stay the SLF1

same.(it depends on the size of the r*

shifts of both DLF and SLF).

(Remember the discussion in Ch.3 DLF1
DLF0
about the different types of shifts
of both AD and SAS). LF
I* = S* I1 , S 1

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