9.

Savings & Investment & Financial Markets: Supply & Demand of Loanable Funds

9.1 Introduction:
 Now that we have an understanding of goods market equilibrium and the factors that affect
savings and investment, we can bring savings and investment together with the interest rate.
 Up until this point we have had two assumptions with respect to savings and investment. First,
we have assumed that investment spending is entirely financed by borrowings. We will continue
to make this assumption. The second assumption was that all savings (leakages) were borrowed
and spent by firms as investment spending. In this section we are going to see how the interest
rate ensures that all savings is borrowed.
 Financial markets are where savings (Lending) and investment (Borrowing) come together and
determine the equilibrium interest rate in the economy.
 The process of economic growth depends on the ability of firms to expand their operations,
buy additional equipment, train workers, and adopt new technologies. Financial markets
provide the opportunity for firms with profitable investments to borrow funds from those with
an excess of funds (savers). Without well-functioning financial markets, firms would not be
able to borrow funds to finance expansion and capital accumulation would be diminished.
 Another important point we will see in this section is that the interest rate is another variable
that can ensure that demand equals supply in the goods market. Up until this point we have
seen how income adjusts to bring about equilibrium in the goods market.
o AE>YYuntil AE=Y
o AE<YYuntil AE=Y
 We also know from looking at the economy from the perspective of leakages and injections,
that income also brought about equilibrium between savings and investment.
o AE>YS<IYSuntil S=I
o AE<YS>IYSuntil S=I
 Because both savings and investment are affected by the interest rate, we can also see how the
interest rate can bring about equilibrium in the goods market.
 We can think of savings as the supply of loanable funds in the economy, and we can think about
investment as the demand for loanable funds in the economy. Therefore, if S>I, essentially, we
have an excess supply of loanable funds or a surplus. As we know, when there is a surplus,
prices decrease. The price of loanable funds is the interest rate.
 If there is a surplus of loanable funds, those that have funds but cannot find someone to
borrow will begin to offer a lower interest rate. As we know, if the interest rate decreases,
people save less, and firms borrow more.
 Therefore, we can see that if S>I (AE<I), the interest rate decreases until S=I. When S=I, we
also know that Y-C-G=I, which also means that Y=C+I+G. Thus, the interest rate can bring
about equilibrium in the goods market.
 If S>ISurplus of Loanable fundsPeople offer a lower interest rateiS & firms borrow
moreI until S=IAE=Y.
 On the other hand, if S<I (AE>Y), we have a shortage of loanable funds. When there is a
shortage of loanable funds, those that want to borrow but cannot find anyone to lend to them
will begin to offer a higher interest rate. As the interest rate increases, people save more, and
firms borrow less. This continues until S=I Y-C-G=I AE=Y
 If S<IShortage of Loanable fundsFirms offer a higher interest rateiS & firms
borrow lessI until S=IAE=Y.
 An important point to make here is that the interest rate adjustment to equilibrium is different
than the income adjustment we have looked at. Although they both lead to equilibrium, the
overall effects are very different. We will look at both effects together in a later section to
reconcile the differences. For now, it is just important to be familiar with the interest rate
adjustment.
 The main difference as we will see later is that if the interest rate adjusts, output is unchanged,
and if output adjusts, the interest rate is unchanged.
 Therefore, they both cannot happen at the same time. It is either one or the other. For the
purposes of this section, we will assume income does not change and as such, the interest rate
will adjust to bring about equilibrium.
9.2 Loanable Funds Model
 In this model we will graph the interest rate on the Y-axis and savings and investment on the x-
axis.
 Savings:
i
o ireturn on savings savingsB-C i
A
C Savings i3

o ireturn on savings savingsB-A i3

o Therefore, we have an upward slopping savings curve. i2

B
i2
B

 Investment: A C
i1 i1
o iCost of BorrowingInvestmentB-A S1 S2 S3 S I1
Investment
I2 I3 I

o iCost of BorrowingInvestmentB-C
o Therefore, we have a downward sloping investment curve.
9.2.1 Loanable Funds Equilibrium
i
 This model ensures that S=I, which we know means that Y=C+I+G. Therefore, the
S

equilibrium interest rate in this model is the interest rate that clears the goods A

market by ensuring that Y=C+I+G or S=I. i*

 As we have shown, higher interest rates lead to higher levels of savings and lower
I
levels of investment. Therefore, to model our savings and investment diagram
with interest rates on the y axis, our savings curve will be upward sloping S*=I* S,I

(iS) and our investment curve will be downward sloping (iI).

 i1: total savings is at Q1 and total investment is at Q2. As a result, there is
excess demand for investment (Q2-Q1Inv > Sav).
 i3: total savings is at Q2 and total investment is at Q1. As a result, there is
excess supply of savings.
 Excess demand for loanable funds (investment) will cause the price of
loanable funds (interest rate) to increase, as firms who want to borrow, but
cannot find borrowings will bid the price up (i). On the other hand, an excess supply of
savings will cause savers who are unable to find firms to lend their funds to, to bid the price
down (i).
 As a result, the market will clear at i2 where Savings equals Investment.
 I3S>IiS & I to i2 and I1S<IiS & I to i2

2
9.2.2 Changes in Savings & Investment

Factors that Shift Savings Curve

Savings
Variable Description Change
Income YC&S S
Fut. Exp. Income YFS & C S
Wealth WS S
Taxes Public Savings S
Gov’t Spending S
i S
Any  Consumption (except form changes in i) S

 Changes in Savings: i S i
S'
S
o1st Graph: SLevel of Equilibrium Quantity of S,I & B
S' i'
i A A
i* B i*
o2nd Graph: SLevel of Equilibrium Quantity of S,I & i'

i I I

Q* Q' S,I Q' Q* S,I

Factors that Shift Investment Curves

Investment
Variable Description Chang
e
MPK MPKBenefits of Using Capital Inv
K-Tax After Tax Return on K Inv
r Higher User Cost of Capital Inv
Positive Expectations More optimistic expectations about the economy Inv
Financial Frictions Increased Financial Frictions make it harder to borrow funds Inv

 Changes in Investment:
o1st Graph:ILevel of Equilibrium Quantity of S,I & i
o2nd Graph:ILevel of Equilibrium Quantity of S,I & i

3
9.2.3 Savings & Investment Analysis i S S
 i S Increase i S'
i'
A
B in Savings A
A
i*
i* and an i'
B
i* C
B
I'
Increase I
i'
I
in I'

Q* Q' S,I Q' Q* S,I I'

Investment: I

oIncrease in Savings shifts the savings curve to S’, which causes a

S,I
decrease in the interest rate. (A-B) Q* Q' Q''

oThe increase in investment shifts the investment curve to the right to I’, which increase the
interest rate. (B-C)
oTherefore, the total effect on interest rates depends on which shift is larger. However, the
equilibrium level of savings and investment increases.
 Decrease in Savings and Increase in Investment:
oThe decrease in savings shifts the savings curve to the left to S’
S'
causing the interest rate to increase. (A-B) i C S
oThe increase in investment shifts the investment curve to the right to I’ i'' B
also causing the interest rate to increase. (B-C) i'

oTherefore, the overall effect is to increase interest rates. However, the i* A

equilibrium level of savings and investment depends on which curve

shifts further. I
 Increase in savings and a decrease in investment:
oThe decrease in investment shifts the investment curve to the left to I’ Q' Q* S S,I
i
causing a decrease in the interest rate. (A-B) S'

oThe increase in savings shifts the savings curve to S’ causing the A

i*
interest rate to decrease. (B-C) B
oTherefore, the overall effect is to decrease interest rates. However, the i'

equilibrium level of savings and investment depends on which curve i'' C

shifts further. I
 Decrease in Savings and a Decrease in Investment: I'

oDecrease in Savings shifts the savings curve to S’, which causes an S,I
Q' Q*
increase in the interest rate. (A-B) i
S'
S
oThe decrease in investment shifts the investment curve to the left to I’,
B
which decreases the interest rate. (B-C) i'
C A
oTherefore, the total effect on interest rates depends on which shift is i*

larger. However, the equilibrium level of savings and investment

increases. I
I'

Q'' Q' Q* S,I

4
5
Fiscal Policy
oS=IY-C-G=I
oExpansionary Fiscal Policy: GS or TCS
oExpansionary Fiscal Policy decreases savings (S to S’: A-B). Holding the interest rate constant, we can
see that savings decreases from point A to B. The demand for loanable funds is still at point A. The
shortage of loanable funds causes firms to bid the interest rate upward. As S'
i S
the interest rate increases, savings increases from B-C (C) and investment
decreases from A-C (I). C
i'
oTherefore, Expansionary fiscal policy reduces national savings and
B
contractionary fiscal policy increases national savings. As the graph shows, i* A

an expansionary fiscal policy reduces national savings, which leads to higher

interest rates and lower equilibrium level of investment and savings
I
(Consumption).
oGSC & I
Q' Q* S,I
oThe increase in government spending causes the interest rate to increase
leading to a decrease in investment and consumption. As a result, government spending crowds out
investment and consumption. Essentially expansionary fiscal policy will cause no change in income but
will cause the % contribution of aggregate demand to change.
oIf the government financed the expansionary policy through taxes, there would be no change in interest
rates and thus no crowding out.

How does this reconcile with the fact that the AE model showed expansionary fiscal policy increased output
with no decrease in consumption or investment?
 When the government increases government spending assuming no change in taxes, the
government had to borrow the funds from national savings. This was shown as the decrease in
savings. What we saw with the AE model was that the increase in government spending led to
firms increasing output, which led to a multiplier effect that increased income. The higher
income increased both consumption and savings (1=MPC+MPS). This higher income would be
exactly enough to shift the supply curve above back to its original level (point A). This would
prevent the interest rate from increasing. Now if for some reason firms could not increase
output, then the savings curve would not shift back to equilibrium and the interest rate would
restore equilibrium. Again, we will look at this in detail in the next section.
oContractionary Fiscal Policy: GS or TCS
S
oG or TS (S-S’: A-B). At point B, savings is greater than investment. i
Again, assuming no change in output, when S>I, AE<Y, the surplus of S'
loanable funds will cause savers to offer a lower interest rate. As the interest
rate decreases, Investment increases from A-C and Savings decreases A
i* B
(Consumption) from B-C.
i' C
oTSiI & S (C)

Q* Q' S,I