Update: 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.

Carmen submitted the following through the “Econ Help Desk“

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

Molly Saso, AP Econ teacher at the International School of the Sacred Heart in Tokyo, asked in an email to the AP Econ email list about Free Response Question #2 from the International exam (form B). The question reads:

2. (a) Assume that businesses are granted a tax credit on spending for machinery. Using a correctly labeled graph of the loanable funds market, show the effect of the business sector’s response on the real interest rate.

Here’s Molly’s email:

“The loanable funds market, in spite of its apparent simplicity, continues to throw up some ambiguities–or perhaps it’s just me who is perplexed.

What would be the impact on the market of a tax credit for spending on machinery? (Q2 on Form B, 2007–all the FRQs are already on AP Central.)

While the intent is indeed to increase planned investment, would firms increase or decrease their demand for loanable funds? To the extent that the tax credit means that there is a greater amount of post-tax profits available for investment, then the demand for loanable funds could decrease; but wouldn’t many firms need to supplement their post-tax profits with a greater demand for loanable funds?

Perhaps, if the impact on demand is indeterminate, the shift would be in supply, since firms would have a greater store of “savings” (retained profits). However, since a shift in supply was the answer to the second part of Q2, I somehow doubt that the examininer would be expecting a supply shift in part (a) as well.

The trouble is that the question asked for no explanation–only a graph to “show the effect”. I wonder what kind of shift was expected?

In perplexity,
Molly”

Molly’s question is a good one, and although I hadn’t spent much time reflecting on this question, her email got me thinking more about this interesting and challenging question. Here’s what I came up with and replied to Molly with. I don’t know if it’s correct or not, but I’d be interested to hear what others thought about this question:

Hi Molly,I’m in Shanghai, so my students also took form B (the international questions). I too found this to be a bit confusing. But as I teach my students, “don’t make the questions more complicated than they have to be, look for the most obvious answer.” Unfortunately, this one had no immediately obvious answer, as you explain below. I think what made it difficult was the term “tax credit on spending for machinery”. I don’t know about you, but this specific term never came up in my class!

Here’s how the question begins: “Assume that businesses are granted a tax credit on spending for machinery”. I interpret this tax credit as an amount deducted from federal income tax, calculated as a fixed percentage of expenditures on, in this case, machinery. In other words, the tax credit is not granted unless the firm undertake investments in new machinery. Your suggestion that the tax credit results in a “greater amount of post-tax profits available for investment” may be mistaking the credit indicated with a reduction in corporate profit taxes. I think if this were a corporate profit tax question then perhaps demand for loanable funds would go down since new investment could come from the now higher profit margins firms receive; in fact, the tax credit is not granted until new investment is undertaken by the firms in the first place.

I would explain this to my students by saying that essentially, the expected rate of return on investments goes up (since fewer taxes will be paid once new machinery is bought), shifting the Investment Demand curve out, thus the Demand for loanable funds, increasing the real interest rate.

That said, I cannot be certain that this is what the AP was looking for, so don’t hold me to it! Writing this email allowed me to really clear this one up, though, so thanks for the inquiry!

Jason

Anyone else have a better answer or something to add?

Powered by ScribeFire.