University of California Los Angeles

Summer 2017 Session A

Economics 102 Macroeconomic Theory
Instructor: Konstantin Platonov
kplatonov@ucla.edu

Lecture 3: Loanable Funds Market

In lecture 2 we showed that real GDP is produced by labor and capital. Capital is a predeter-
mined variable. The equilibrium level of employment is determined on the labor market where
households supply labor services and firms demand them. We also looked at how some types of
changes in the economy can affect the amount of produced GDP.
In this lecture, we will look at the loanable funds market. In a closed economy, the equation

Y =C +I +G (1)

says that the amount of goods produced must be allocated to consumption, investment, and
government spending. We will show that the loanable funds market determines the equilibrium
level of investment and savings, and hence consumption.
The loanable funds market is a market where funds are traded. The price of loanable funds is the
interest rate. On the supply side of the market, there are economic agents that have temporarily
excess funds. These economic agents are savers. On the demand side, there are economic agents
that need additional funding to finance their projects (investment). These economic agents are
borrowers. Typically, at the aggregate level, households are savers and firms are borrowers.
Government can be on either side of the market. We adopt a convention that government is on
the supply side, even though it may be borrowing money.
Following the steps from Lecture 1, we know that equation (1) can be written in the form

I = S, or I = SP + SG . (2)

We need to understand how demand for loanable funds and supply of loanable funds are de-
termined, and what factors can influence the equilibrium on the loanable funds market: the
equilibrium amounts of investment, savings and the interest rate.

1 Loanable Funds Market: Investment Demand

Capital is typically owned by rental firms. These are the firms that keep capital, maintain it,
make investment and rent out their services. For instance, if a company wants to build a new

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house in Westwood, it is very likely that this housing firm is going to rent excavators, cranes and
concrete mixers from a rental company.
In Lecture 2 we showed that demand for capital is given by equation
R
MP K = . (3)
P
Here, R/P stands for the rental rate of capital. We say that firms that produce goods compare
the marginal product of capital, the marginal benefit from capital, and the real rental rate, the
marginal cost of hiring capital. An individual firm is expected to increase its capital up to the
point where the M P K is equal to the real rental rate, so that equation (3) holds. However, at
the macro level, the supply of capital is fixed. The rental rate adjusts to clear the market for
capital services.
What determines incentives of rental firms to invest in capital? When a rental firm supplies
capital services, its real revenue would be (R/P )K. But holding capital has costs. Firstly, there
are maintenance costs: rental firms have to fix broken capital. In Lecture 1, we introduced the
depreciated rate denoted . This is the percentage of capital that needs to be repaired. A rental
firm would need to buy K units of capital to replace the broken capital. Secondly, there is also
implicit cost of capital that has to be taken into account. At the beginning of the year, a rental
firm can sell all its capital, earn K units of output and put this money into banks. This would
deliver income of rK where r is the real interest rate in the economy. Summing up, holding
capital delivers the following real profit to a rental firm:
R
K K rK = M P K K (r + )K. (4)
P
Next, divide this equation by K to obtain the profit per unit of capital:

M P K (r + ). (5)

Obviously, the more money makes a rental firm per unit of capital, the more capital it would
like to have. Therefore, we can say that demand for investment is an increasing function of the
profits of rental firms. Mathematically, we can write the investment demand function:

I = I (M P K (r + )) . (6)

We will focus on the interest rate as the most important determinant of investment. Graphically,
the investment demand curve is decreasing in the interest rate (see Fig. 1). Indeed, when the
interest rate is high, the opportunity costs of investing in capital are big. Rental firms will lease
capital only to highly productive customers that are able to cover the high opportunity costs.
Therefore, the rental firms would want to hold less capital.
Changes in the real interest rate r correspond to movement along the investment demand curve.

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Determinants of the investment function that shift the demand curve (see Fig. 1):
The marginal product of capital, M P K. The bigger is M P K, i.e. the more productive is
the capital, the more money final-good firms are ready to pay for rental services. For the
factors that influence M P K, see Lecture 2.
The depreciation rate, . When the depreciation rate is large and capital depreciates fast,
it is expensive for rental firms to keep a large stock of capital. They would prefer to have
less capital, and investment would be smaller.

Figure 1: Investment Curve: Slope and Shifts

2 Private Savings

2.1 Why Do People Save Money? The Life-Cycle Hypothesis

Households receive disposable income. From Lecture 1, we know that disposable income YD is
split between consumption C and private savings SP :

YD = C + SP . (7)

How do they allocate the disposable income between consumption and savings? The main fac-
tor is the intertemporal preferences of households. Individuals prefer to smooth consumption
(this concept is called consumption smoothing). This idea states that households prefer to keep
consumption at an approximately constant level. By saving money when income is high and
borrowing money when income is low, households can smooth out consumption over time.1

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The Life-cycle hypothesis was suggested by Franco Modigliani and Richard Blumberg in 1954.

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Example 1: Consumption and Income. A person plans to work Twork = 40 years and then
retire. She has no initial wealth. The expected length of life is Tlife = 60 years (we ignore
the period of time before workchildhood and college years). She expects her income to be
Ywork = $120 thousand per annum (assuming no taxes) and no income during retirement, Yret = 0.
For simplicity, suppose the interest rate is equal to zero. How much would she consume per
annum? What is the dynamic path of her savings and wealth?

Life-time income LT I = Twork Ywork = 40 (years) $120 (per year) = $4,800 (8)
LT I $4,800
Consumption C = = = $80 (per year) (9)
Tlife 60 years
Savings during working period Swork = Ywork C = $120 $80 = $40 (per year) (10)
Accumulated wealth by retirement = Twork Swork
= 40 (years) $40 (per year) = $1,600 (11)
Savings during retirement Sret = Yret C = $0 $80 = $80 (per year) (12)
Accumulated wealth by end of life = Wealth at retirement + Tret Sret
= $1,600 + 20 ($80) = $0 (13)

The total income earned over her life is $4,800. She distributes this income evenly across all
the years and consumes $80. During her working period, she saves $40 per annum, and by
the beginning of retirement she accumulates wealth of $1,600. This wealth will be spent on
consumption during her retirement (she will have no income during retirement!), so that by the
end of her life she would not leave any money. Fig. 2 illustrates this graphically. Savings allow
the individual to transfer part of her income to the future.
End of Example 1.
Example 2: Consumption and Unanticipated Change in Income. How does consumption
and savings respond to unanticipated changes in income? Suppose that at the beginning of her
career she expects her income to be $120K, but after 20 years of work her income suddenly
doubles and remains that high till the end of her working period. Her compensation would be
$120 during first 20 years, and her income would double thereafter till she retires.
Before the change in income at t = 20, the situation coincides with the one from Example 1.
By the moment of the arrival of the good news, she will have accumulated wealth of

20 Swork = 20 (years) $40 (per year) = $800.

She needs to re-evaluate her life-time budget, taking into account bigger income and accumulated

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 Figure 2: Consumption Smoothing: Dynamic Diagrams (Example 1)

wealth.

New life-time income LT Inew = $800 + 20 (years) $240 (per year) = $5,600 (14)
LT I $5,600
New consumption Cnew = = = $140 (per year) (15)
Tremaining life 40 years
New savings during working period Swork,new = Ywork,new Cnew
= $240 $140 = $100 (per year) (16)
Accumulated wealth by retirement = $800 + 20 (years) $100 (per year) = $2,800 (17)
Savings during retirement Sret = Yret Cnew = $0 $140 = $140 (per year) (18)
Accumulated wealth by end of life = Wealth at retirement + Tret Sret,new
= $2,800 + 20 (years) ($140) (per year) = $0 (19)

End of Example 2.
Example 3: Consumption and Anticipated Change in Income. How does consumption
and savings respond to anticipated changes in income? Suppose instead that at the beginning of
her career she knows the following. Her compensation would be $120 during first 20 years, and

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 Figure 3: Consumption Smoothing and an Unanticipated Increase in Income (Example 2)

her income would double thereafter till she retires. Now,

Life-time income LT I = 20 (years) $120 (per year) + 20 (years) $240 (per year)
= $7,200 (20)
LT I $7,200
Consumption C = = = $120 (21)
Tlif e 60
Savings during first working period Swork,1 = Ywork,1 C = $120 $120 = 0 (22)
Savings during second working period Swork,2 = Ywork,2 C = $240 $120 = $120 (23)
Accumulated wealth by retirement = 20 Swork,1 + 20 Swork,2
= 20 0 + 20 $120 = $2,400 (24)
Savings during retirement Sret = Yret C = 0 $120 = $120 (25)
Accumulated wealth by end of life = Wealth at retirement + Tret Sret
= 2,400 + 20 ($120) = 0 (26)

We observe that her consumption goes up even before her actual income goes up. This happens so
because, when making a decision regarding consumption, she takes into account not only current
income, but also its expected future values. Her savings are equal to zero during the first period
of life, but this is not a problem because she will be able to save out of bigger income in the
future. Fig. 4 plots the new dynamics.
End of Example 3.

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 Figure 4: Consumption Smoothing and an Anticipated Increase in Income (Example 3)

To sum up, we see that the main role of savings is transferring wealth across different periods of
life. We also see that consumption C and private savings SP depend in disposable income YD ,
but, when expectations are in play, this relationship may not be very straightforward.

2.2 Private Savings and the Interest Rate

How do consumption and private savings depend on the interest rate? The answer is: it depends.
In this subsection, we will discuss the relationship between them. We will not develop a rigorous
theory because it would be rather cumbersome. Instead, we will rely on economic intuition.
When the interest rate is not equal to zero, a households faces a tradeoff. On the one hand, the
household should take advantage of a high interest rate. The household should sacrifice current
consumption, save more money, receive big interest income and enjoy greater consumption in
the future. This is called the intertemporal substitution effect: an increase in the interest rate
reduces current consumption and raises savings. On the other hand, when the interest rate is
high, the household can consume more now and save less and enjoy a high level of consumption
in the future. This is called the intertemporal income effect: an increase in the interest rate raises
current consumption and reduces savings. The total change in current consumption and savings

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(the total effect) depends on the magnitudes of the substitution and income effects.
C SP
< 0 and >0 Substitution effect > Income effect (27)
r r
C SP
> 0 and <0 Substitution effect < Income effect (28)
r r
C SP
= 0 and =0 Substitution effect = Income effect (29)
r r
Fig. 5 shows all possible cases.

Figure 5: Private Savings and the Interest Rate

Empirical studies demonstrate that the magnitude of the substitution effect is slightly bigger than
the income effect. This means that graphically the private savings supply curve is very steep and
very close to being vertical. The case when the income effect exceeds the substitution effect is
unrealistic.

3 Public Savings and National Savings

Another important component of national savings is public savings made by the government. In
Lecture 1, we showed that
SG = T G = T x T r G. (30)

All three variables are policy variables. The magnitude of taxes T x is determined in tax codes and
cant be changed easily. The magnitude of transfers T r is determined by social responsibilities of
government (social security, social insurance, etc.). Finally, government spending G is determined
by the current needs of the economy. Usually, SG is simply a number.
The total savings function, or the loanable funds supply function, is a sum of private and public
savings (remember the foreign savings are absent in a closed economy):
S = SP (YD , r) + SG (31)
= YD C(YD , r) + (T G) (32)
= Y T C(Y T, r) + T G (33)
= Y C(Y T, r) G. (34)

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In this equation, real GDP Y comes from the equilibrium on the labor market (see Lecture 2).
Government determines G and T , and given their values, households decide how much to con-
sume C. The slope of the savings curve is determined by the consumption function (see equations
(27) (29) and Fig. 5). Changes in the real interest rate correspond to movement along the sav-
ings curve.
All other variables determine the position of the savings curve.
The savings curve shifts to the right if
Real GDP Y increases
Government spending G decreases
Net taxes T increase
Consumers want to consume less and save more (the whole function C shits down)
To sum up, the total savings function is a function of the form S(Y, r). It is positively related to
income Y and non-negatively to the interest rate r. Fig. 6 shows two possible cases that differ
in magnitudes the substitution effect and the income effect.

Figure 6: Total Savings and the Interest Rate

4 Loanable Funds Market Equilibrium

Now we put all the pieces together. There are two sides on the loanable funds market: demand
and supply. On the demand side is investment. This is a decreasing function I(r). On the supply
side are total savings. The total savings curve can be vertical or have a positive steep slope.
Fig. 7 shows the case when the savings curve is vertical. The equilibrium determines the interest
rate r, the level of investment I and the level of savings S.
How does this equilibrium change in response to shocks? To be specific, we assume the savings
curve be vertical.
Example 4: Technological Improvement. When technology A improves, the marginal prod-
uct of capital M P K increases (see Lecture 2). Therefore, demand for investment increases shifting
the investment curve to the right. At the same time, since capital and labor are more productive,

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 Figure 7: Loanable Funds Market

output increases, and the savings curve shifts to the right. The effect on the interest rate is
ambiguous. The equilibrium levels of investment and savings increase. The economy will accu-
mulate extra units of capital by the end of the year. This will increase production capacities in
the future. Fig. 8 shows the change of the equilibrium.
Summary:
A = (1) Y = S
(2) M P K = I

Figure 8: Technological Improvement

Example 5: Fiscal Expansion Financed by Borrowing. Suppose government increases

its spending G. What happens on the loanable funds market? The investment demand curve
remains unchanged. The savings curve shifts to the left because government saves less now. As a
result, the equilibrium interest rate goes up, and the equilibrium level of investment falls. Fig. 9
shows these changes. This is called the crowding out effect: government spending crowds out
private investment. In order to borrow money, government has to offer a higher rate of return
than the market does. Since the interest rate is the opportunity cost of holding capital, rental
firms do not want to invest as much as before. The long-run consequences of such a policy may
be slower accumulation of capital because firms prefer to invest less.
Summary:
G = S = r = I

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 Figure 9: Fiscal Expansion and Borrowing

Example 6: Fiscal Expansion Financed by Taxes. Example 5 tells us that if government

intervenes in the loanable funds market, it suppresses private investment because it has to compete
for funding. What if government raises taxes to finance its extra spending? As it turns out, the
results are similar. On the one hand, the increase in government spending directly reduces total
spending. On the other hand, the increase in taxes raises total savings by reducing disposable
income and consumption. Which effect dominates? The impact of taxes is weaker. Lecture 3
Practice Problems, Question 2 asks you to investigate this question in detail. The savings curve
shifts to the left. Fig. 10 shows the change of the equilibrium.
Summary:

G and T = S (even though C ) = r = I

Figure 10: Fiscal Expansion and Tax Increase

Further Reading
Mankiw Ch. 3, 16, 17

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