Jun 02 2008
Loanable Funds vs. Money Market: what’s the difference?
Published by Jason Welker at 11:05 am under
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WikipediaUpdate: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.
*Click on a graph to see the full-sized version
Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money
Market diagram.
This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.
You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.
Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.
When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends. 
Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.
Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.
Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.
- When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
- The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
- In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
- As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
- This causes crowding out of private investment.
Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.
- Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
- Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
- This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.
What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.
On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).
It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- From the Help Desk – more on loanable funds and the money market
- 2007 AP FRQ #2 – Tax credits and the loanable funds market
- A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
- The almighty bond market: Niall Ferguson’s concerns about the US deficit explained
- A common error – confusing the money market and market for foreign exchange
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If the real interest rates for the US Dollar are low, there will be an increase in entrepreneurial projects, and the amount of loans given out by the American banks on a whole. This means there will be an increase in the amount of funds households and firms have.
Ceteris Paribus, on the foreign exchange market, this will mean an increase in the supply of the US Dollar, resulting in the devaluation of the US Dollar.
The real interest rates are very low in the United states, this will cause many people to borrow money for investment.Low interest rates mean a low rate of return if the money is placed in a savings account therefore firms can make more profit by investing in capital. This will increase the real wealth of investors and make them spend more money.
If the real interest rates in the US decrease then there will be a increase in investment in capital and entrepreneurial ventures. Therefore, the investment will increase everyone’s real wealth which will increase the consumption. So because everyone has more funds there is an increase in the spendable supply of the US dollar so the value of the US dollar will decrease.
Lower real interest rates in the United States would affect Demand for the US dollar on foreign exchange markets through increases in household’s likeliness to borrow money, firms likeliness to invest in capital, factories, etc and thus, like Marco said, loans given by banks are increased and thus the amount of money in circulation increases, driving up the price of the US dollar. Demand for the US dollar on foreign exchange markets increases when interest rate go down due to the above, but demand for the US dollar also increase when from a low interest rate, the interest rates increase slightly, giving evidence to suggest that interest rates will increase in future; which will happen because a slight increase in interest rates prompts households to take out loans before the interest rates rise again.
When investors are deciding whether or not to make a loan in order to make an investment, there are two factors which they must take into account: the expected ate of return (expected future profit they will gain from making this investment), as well as the real interest rate. In order for the firm to invest, r (the expected rate of return) must exceed i (the real interest rate). Thus, according to this, Total Investment in a country can be depicted as a graph which plots the real interest rate against the Quantity of funds for investment. When real interest rate is high–say, 15 %–very few projects have an expected rate of return this high; therefore, few firms will be willing to invest, for it would be more profitable for them to keep their money in the bank and receive the interest from this money. However, as real interest rate decreases, the quantity of funds loaned for investment increases as more projects have an expected rate of return above the real interest rate. Because of this, there is an inverse relationship between real interest rate and the quantity of funds loaned for investment.
by the way, i don’t know anything on foreign exchange rates blah blah blah so i just wrote stuff on what we learned in class
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As savings increase, there is a direct correlation between between the low interest rates and the amount of loans given out by the government. Thus, the amount of US dollars in circulation increases, devaluing the US currency in the worldwide market.
With lower interest rates, financial capital will flow out of the country. This means a lower demand for the currency and a weaker currency. The weaker currency leads to more exports and fewer imports, which increases aggregate demand.
Lower the interest rates the greater the effect on nominal GDP. Loans from banks increase so that more people will spend $$ so $ circulation increases increasing the value of the US dollar. Demand for the US dollar will increase in foreign markets this proves that interest rates will increase eventually.
Lower real interest rate in the U.S. would mean that a foreign country is less encouraged to invest in U.S. assets because of lower profit later on. Thus, the foreign country decreases its supply of currency in the market, and that foreign currency will appreciate. Because of the appreciation, U.S. currency relatively depreciates.
Interesting to think about. If interest rates on loans from banks go up, domestic investment will decrease because the opportunity cost of obtaining the money is higher (it would require a higher rate of expected return for companies to be willing to invest). This would decrease AD, causing higher price levels, which causes the nation’s currency to depreciate.
However, at the same time, if interest rates on bonds and returns on investments are higher, foreigners would be more willing to invest in the country because the rate of expected return is higher. This would cause the country’s currency to appreciate because there is more demand for that country’s currency.
How HIGHER real interest rates in U.S. would affect Demand for the US dollar on foreign exchange markets, the exchange rate of the dollar compared to foreign currencies, and U.S. exports?
When the Fed increases the nominal interest rate, the real interest rate rises temporarily and investment and expenditure on consumer durable decreases. An increase in the interest rate means that the U.S. interest rate increases relative to the interest rate in other countries. Foregners are attracted to the higher interest rate they can now earn on U.S. bank deposits and bonds, which increases the demand for U.S. dollars. With more dollars demanded, the price of the dollar rises on the foreign exchange market. U.S. exports decrease sice foreigners must now pay more for goods and services of U.S.
Assuming this IR refers to bank, lower real interest rates will discourage people invest, and investment is one of the determinant of aggregate demand. Because investment decreases, aggregate demand will also decrease.
Assuming this IR refers to interest rates on loans from banks, if it increases, people will invest less. Thus, it affects aggregate demand, and thus the dollar will depreciate.
Why is the interest rate of the money market nominal and the loanable funds real? Shouldn’t both be adjusted for inflation to show the actual fluctuation of interest rates??
Why are there comments back from last year?!
Oh wait, this is a revival of old stuff as hinted in the newsletter.
Are “tight money” and “easy money” strictly technical terms or are they AP Econ-speak?
kos o5tkom wen el graph ya wlad el ka7beh
where is the graph??
There’s your graphs! Happy?
The market for loanable funds is basically talking about the excess reserves in the commercial banks, right? Suppose the intersection of demand and supply on the market for loanable funds was originally at the Fed’s target interest. What if a shift in either demand or supply occurs due to one of the determinants uncontrollable by the Fed? Let’s just say that investors suddenly feel very bright about future opportunities due to some technological breakthrough, so demand increases. Now, however, the interest rate is no longer at the Fed’s original targeted rate; it’s higher – does the Fed then implement expansionary monetary policy to bring interest rates back down?
An echo to Angel’s point, why nominal interest rate for the money market and real interest rate for the loanable funds one? Is it because inflation doesn’t directly affect the money supply as a whole? Or?
Either way, I’m glad this post exists. Clarifies quite a bit.
[...] Crowding-out occurs because of the inverse relationship between real interest rate and the demand for investment funds. Private investors face higher real interest rates when the government finances its spending by selling bonds to the public (in other words, borrowing from the public). To see the graphs for the money market and the loanable funds market, read my recent blog post, “Loanable Funds vs. the Money Market: what’s the difference?” [...]
Responding to Angel’s question, i am not sure if this is right but it doesn’t hurt to try right? haha. Well, in the money market, bonds are considered a factor. Fed can buy or sell bonds and somewhat control the money supply and money in circulation. However, the money hold by fed’s reserve are not counted in the money supply therefore, they are not directly affected by inflation rate. On the other hand, Loanable funds ARE money in circulation and hold by the publics and banks. The banks loan money to the publics to increase their disposable income etc. Therefore, it is directly affected by inflation. If the interest rate is low, no one would want to save their money in the bank, they would spend more right now, and vice versa.
So the dynamics of the loanable fund market and the inverse relationship between investment and saving basically cause crowding out, right? Or is crowding out only caused by shifts of the loanable funds demand curve?
What’s the difference between loanable funds and bonds
The loanable funds market isn’t really a market right? It’s a theoretical market that includes all of the banks, right?
I think both the loanable funds market and money market are types of markets. However, the money market is more focused on government intervention in the market, whereas the loanable funds market focuses more on loans made by commercial banks.
In response to Charlie: Isn’t loanable funds the loans made by commercial banks? Bonds are the way in which the government borrows from the public.
@ Margret. I think its the shifting of the demand curve that causes crowding out as it causes everything eventually leads to crowding out. Someone correct me if im wrong?
TIM: I think that BOTH shifting of the demand and supply curve of loanable funds causes crowding out. This happens when the government deficit spends to stimulate AD, which is why there is the criticism of the “crowding out” effect.
When Government issues new debt securities, supply of bonds goes up, price of bonds goes down, interest rates of the bonds go up, households by more bonds, thus the supply of loanable funds go down, real interest rate increase, demand for loanable funds decrease, and thus investment decreases.
On the DEMAND side, government spending increases, demand for loanable funds increase as the government is borrowing from the public, real interest rate increases, thus the quantity supplied of loanable funds increase, and private investment decreases.
According to my understanding…
margaret: crowding out is caused by the relationship between deficit spending and real interest rates. when the government engages in deficit spending, it has to sell bonds to finance the spending. selling bonds –> decrease in supply of loanable funds –> higher real interest rates –> discourages spending –> decrease in AD. This crowds out the initial intent of the government spending which was to increase AD. So it’s not “the inverse relationship between investment and saving,” it’s the inverse relationship between government deficit spending and consumer spending (or real interest rate and the demand for loanable funds, same thing).
chawls: bonds are the securities sold to the public. loanable funds are the liquid money that households put in the bank. aka when households put money in savings accounts, that money becomes loanable funds. so when interest rates are high, households are more inclined to save; thus supply of loanable funds increases. when interest rates are low, households would rather spend than save and so demand for loanable funds is high and supply of them is low.
jack: it’s the market representation of all the money that’s available for lending to firms and households for spending.
so basically the government is competing with the public for loanable money from the banks? so more demand for money=higher interest rate?
Cassy – The market for money graph shows that the supply for money is vertical and the demand for money is downward sloping. So yes, an increase in the demand for money, shifting it right, would then produce a higher interest rate, unless the supply for money increases as well, which would shift interest rate back to the original position.
With lower interest rates, there will be a lower demand for the currency and a weaker currency because financial capital will flow out of the country. Weaker currency leads to increase in exports and decrease in imports, therefore aggregate demand will increase.
HA! This is so much better than the explanations in the textbook. I just can’t seem to focus when I’m reading the text… Thanks anyways!
OH now I got it by reading all the comments I now get some sense of what loanable funds are
and what money markets are! thanks everyone
This article clarifies the distinction between the money market and the market for loanable funds. I think it is important to remember that there is a direct relationship between real interest rate and Supply of Loanable Funds and that it is the nominal rate determined by the Fed in the money market that shifts the Money Supply in or out.
For the money supply graph, the Y axis is nominal interest rate because that is what the fed controls with its monetary policy. The real interest rate includes the inflation rate, and this is what matters for loanable funds because there might be a because there might be a significant increase in nominal interest rate, but if it is lower than the inflation rate, there will not be any increase at all, and might even decrease
oh!!! this is the one that used to have no graphs ^^
anyway, this shows the direct relationship between the real interest rate and loanable fund supply. becayse the loanable fund is determined by the inflation rate which includes the real interest rate.
[...] http://welkerswikinomics.com/blog/2008/04/10/loanable-funds-vs-money-market-whats-the-difference/ [...]
Jason,
This is a truly excellent post.
One question. You did not address the government’s demand for money in the short term money market (ie, borrowing via T-Bills and other short term loans), shifting the Dm to the right and raising interest rates in the money market.
Do you see that as another adjustment to this post for the future?
Hope all is well in Switz!
Steve
Steve,
I’d love it if you would add to this post. I am always trying to learn more about how monetary and fiscal policies interact… I don’t know much about the short-term money market, what can you tell me?
In today’s credit reliant society, it is easy to confuse the money market and loanable funds market. The money market however only includes M1, M2 and MZM, which are all forms of personal deposits, savings and long term savings (money zero maturity). The loanable funds market is a simple supply and demand diagram, showing us that interest rates change as expected according to supply and demand. This demand for money however is different from the “normal” money market. Loanable funds, a.k.a. loans, is a created form of money, which essentially speaking is not really owned by the borrower, so can not be counted in the money market. Both are interlinked, but it is intersting to note that the loanable funds market will have a larger effect on the investment side of AD, while the money market will influence the consumption (but also investement) side of AD.
There is a difference between the money market and loanable funds. The money market includes transaction demand, asset demand and total demand for money. This includes M1, M2 and MZM. The loanable funds market, on the other hand, is where borrowers demand loanable funds and the savers supply the loanable funds. This is a simple supply and demand diagram, where supply (savers) is a direct relationship between interest rates and the supply of loanable funds and the demand (borrowers) is an inverse relationship. The money market has a downward sloping demand for money and a vertical supply of money.