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Econ 141 - Ch.4

Econ 141 - Ch.4

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Published by coldpassion
Econ 141, By Dr.Alwosabi
Econ 141, By Dr.Alwosabi

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Published by: coldpassion on Dec 07, 2009
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Econ 141 - Ch.41
Notes on Chapter 4
Loanable Funds and the Real Interest Rate
Potential GDP depends on the quantity of productive resources. Thegrowth rate of PGDP depends on how rapidly the resources grow.
One of the major resources that is important to grow is the economy'scapital stock.
The capital stock includes business capital as well as inventories.
The economy's
capital stock
is measured by its total physical quantityand quality of plants, machines, equipments, buildings, inventories of rawmaterials and semi-finished goods, highways, schools, etc.
In addition to the privately owned capital stock resulting from privateinvestment (business investment plus investment in new homes andadditions to inventories), we also have publicly owned capital stock in theform of 
social infrastructure capital
(highways, dams, schools).
Social infrastructure capital is primarily created by governmentinvestment.
The capital stock is determined by investment decisions.
The funds that finance investment are obtained in the market for loanablefunds.
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 loanablefunds market, we have to understand the meaning of the interest rate anddistinguish between nominal interest rate and real interest rate. Classical
Econ 141 - Ch.42
theory treated saving as a direct function of the rate of interest andinvestment as an inverse function
Interest rate
is the price of fund (loan). It is the rate of interest chargedfor the use of money, usually expressed as an annual percentage. Therate is derived by dividing the amount of interest by the amount of moneyborrowed.
Example:If a bank charged $50 a year to borrow $1,000, the interest rate would be5%.
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 nominalinterest 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).
real interest rate (r)
is the quantity of goods and services that a unitof 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 theopportunity cost of retained earnings.
Econ 141 - Ch.43
Suppose a bank has made a one-year loan of 1000 dinars withnominal interest rate = 5%. At the end of the year, the bank wouldreceive 1050 (100 * 1.05). That is, the bank gained 5%. Supposethe inflation rate of that year = 4%. The bank real gain or realinterest rate = 5% - 4% = 1%
Exercise:If real interest rate is 5 % and inflation rate is 4%. What would be thenominal interest rate?
Uses and Resources of Loanable Funds
Loanable funds are used in three purposes:1. Business investment2. Government budget deficit3. International investment or lending
Loanable funds come from three resources:1. Private saving2. Government budget surplus3. International borrowing
The Demand for Loanable Funds
quantity of loanable fund demanded
is the total quantity of fundsdemanded to finance investment, the government budget deficit, andinternational investment or lending during a given period.
This quantity depends on1. The real interest rate2. The expected profit rate3. Government and international factors

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