Loanable Funds Development Plans© Day 1 Name _____________________

By Mike Fladlien

**The Loanable Funds Market**

In AP Macroeconomics, the Loanable Funds market is a hypothetical market that brings savers and borrowers together.[1] This topic is abstract and is a source of confusion for both teachers and students of AP Macroeconomics. In this lesson, I develop a model that can be used to answer questions that might appear on the AP examination. I used the best resources in developing this lesson plus my 10 years of experience.[2]

Why is the Loanable Funds market important? Why should students learn about this model? Savings is used to invest in the future. Savings fuels GDP growth which means more jobs and more income. In an introductory class, an increase in capital or technology shifts the PPF, SRAS, and LRAS curves to the right. As these curves shift, more can be produced at a lower cost so more wants and needs are met which ameliorates the fundamental problem of economics: scarcity. This is shown in Figure 1.

A high level of savings will sustain a high level of output. Savings is the fuel that fosters long-run growth.

If you have learned the Solow Growth Model, then an increase in capital per worker will shift the aggregate production function upward so that more can be produced with the same amount of labor. This is demonstrated in Figure 2.

**Let’s Begin**

The "**real interest rate**" is approximately the nominal interest rate minus the inflation rate.[3] The real interest measures the interest rate expressed in terms of a basket of goods.[4] In other words, if $1 buys a basket of goods this year, then $1.10 would be the equivalent value of the basket in the future. For the borrower, they give up 10% future consumption. The lender receives 10% more. In the Loanable Funds market, the real interest rate, r, is measured on the vertical axis. The quantity of Loanable Funds is measured on the horizontal axis.

In the Loanable Funds market, the equilibrium interest rate and the equilibrium quantity of funds demanded is determined by supply and demand.

**Investment Demand**

Investment demand is “Firms desired or planned additions to physical capital (factories and machines) and to their inventories.”[5] A firm’s investment demand is inversely related to the real interest. At high real interest rates, firms will demand less Loanable Funds than at lower real interest rates. Since the relationship is inverse, the firm’s demand for Loanable funds is downward sloping and to the right. An example will clarify a firm’s investment demand.

Assume that Juan is considering an investment that he expects to generate revenues of $100.00 in a fiscal period. Assume also that the cost of the investment is $88.00. Juan expects to make a $12 profit or a 13.6% return on investment. If the interest rate is 14%, then the cost of borrowing is greater than the benefit so Juan will not borrow. If the interest rate is 10%, Juan will find it profitable to borrow. Juan will demand loanable funds.

Juan will demand loanable funds as long as the return on investment exceeds the interest rate. As the interest rate drops, there are more profitable investment opportunities so Juan will demand a higher quantity of funds.

Suppose that Juan’s investment demand is given by: Q_{lf} = 100 – 20r, where “r” is the real interest rate. Juan’s investment demand is given in Table 1, “Investment Demand” below. The table is graphed in “Investment Demand, Ig”.

From the table, Investment Demand, Juan will demand $20 dollars when the real interest rate is 4%. As the interest rate decreases, Juan will demand a greater quantity of loanable funds. The demand for Loanable funds is inversely related to the real interest rate.

**Section Review**

1. Refer to the Graph, Investment Demand, Ig. If the real interest rate is 2.5%, what quantity of loanable funds would Juan demand?

2. Using the formula: 100 – 20r, if the real interest rate is 3.5%, what would be Juan’s quantity of loanable funds he demands?

3. Say that the nominal rate of interest on a loan from Community Bank is 8% and the expected rate of inflation is 5%. Calculate the real interest rate.

4. Juan can buy a used photocopier for $50. Does the purchase of a used product count as investment demand?

5. Juanita, Juan’s wife, has a catering business. Calculate her return on investment if she expects to have total revenues of $800 and total costs of $750.

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[1] http://en.wikipedia.org/wiki/Loanable_funds

[2] __Macroeconomics (6th Edition)__ by __Andrew B. Abel__, Ben S. Bernanke, and Dean Croushore; __Macroeconomics: Principles and Applications, Reprint__ by Robert E. Hall and Marc Lieberman

[3] http://en.wikipedia.org/wiki/Real_interest_rate

[4] Blanchard, Oliver, Macroeconomics, Prentice-Hall, 2^{nd} ed., pages 268-269.

[5] http://www.lse.co.uk/financeglossary.asp?searchTerm=&iArticleID=2222&definition=investment_demand