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Loanable Funds Market. The Circular Flow Diagram. Four key markets coordinate the circular flow of income. The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income.
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The Circular Flow Diagram • Four key markets coordinate the circular flow of income. • The resource marketcoordinates the actions of businesses demanding resources and households supplying them in exchange for income. • The goods & services market coordinates the demand for and supply of domestic production (GDP). • The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. • The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments.
Realinterest rate Moneyinterest rate – = Loanable Funds Market • The interest rate coordinates the actions of borrowers and lenders. • From the borrower's viewpoint, interest is the cost paid for earlier availability. • From the lender’s viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future. • The money and real interest rate: • When inflation is anticipated, lenders will demand (and borrowers pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar. • This premium for the expected decline in purchasing power of the dollar is called the inflationary premium. Inflationarypremium
Here, the moneyand real interestrates are equal i = r = Inflation and Interest Rates Loanable Fundsmarket InterestRate S (stable prices expected) .05 D (stable prices expected) Quantityof funds Q • Suppose that when people expect the general level of prices to be stable (zero inflation) in the future, a 5% interest rate brings equilibrium in the loanable funds market. • Under these conditions, the money and real interest rates will be equal (here 5%).
S (5% inflation expected) Inflationary premiumequals expectedrate of inflation i = .10 D (5% inflation expected) Inflation and Interest Rates Loanable Fundsmarket InterestRate S (stable prices expected) .05 r = D (stable prices expected) Quantityof funds Q Q • When people expect prices to rise at a 5% rate, the money interest rate (i) will rise to 10% even though the real interest rate (r) remains constant at 5%.
Capitalinflow D2 Capitaloutflow D1 Interest Rates and Capital Flows Loanable Fundsmarket Domesticsaving InterestRate Supply ofloanablefunds r2 r0 r1 D0 Quantityof Funds Q0 Q2 Q1 • Demand and supply in the loanable funds market will determine the interest rate. • When demand for loanable funds is strong (D2), real interest rates will be high (r2) and there will be a inflow of capital. • In contrast, weak demand (D1) and low interest rates (r1) will lead to capital outflow.
- + = + Budget Deficit Exports Imports Investment Net Saving GovernmentPurchases - - = + + Taxes Exports Imports Investment Net Saving GovernmentPurchases + = + + + Investment Imports Taxes Exports Net Saving Leakages Injections Leakages and Injections from the Circular Flow of Income • Budget deficit = (government purchases - taxes): • Which may be re-written as: • Therefore, when the loanable funds and foreign exchange markets are in equilibrium, leakages from the circular flow of income (savings + imports + taxes) are equal to injections into it (investment + government purchases + exports).
injections leakages The Circular Flow Diagram • Macro equilibrium will be present when the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop). • This condition will be present when the (investment, government purchases, & exports) into the circular flow … equal the(saving, taxes, and imports) from it. • Hence, when equilibrium is present in the loanable funds and foreign exchange markets, injections equal leakages and Macro equilibrium will be present.
