202-T&C-8 - Econ 202 Terms and Concepts 8 THE MARKET...

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Econ 202: Terms and Concepts 8: THE MARKET FOR LOANABLE FUNDS The market for loanable funds is the credit market in which money is loaned by banks and borrowed by investors. Banks are on the supply side of this market, and investors needing money for capital acquisition are on the demand side. It follows that the demand for borrowed money is directly related to the willingness of investors to expand their physical capital. . (Borrowing is also done by consumers, but we will ignore consumer debt in this discussion because we are mainly interested in investors' access to credit over the business cycle.) The price of money is the interest rate. Interest paymens are income to the bank and a cost of production to the investor. In keeping with our understanding of the laws of supply and demand, banks offer more money to lend when interest rates are high, while investors will demand more money to borrow when interest rates are low. However these curves too may shift back and forth over the course of the business cycle, and the stability of both curves is what will interest us. Interest Rate, r Funds, F 0 Supply, the Banks Demand, Investors The post-Keynesian view of the investment demand function is that is not very stable; in other words it shifts back and forth quite a lot during the business cycle. The decision that investors are making is a long-term, high risk capital acquisition decision. If there is no market for their product, they will be paying back debt on their capital while the capital stands idle. This picture of investment is one in which investors are cautious, only embarking on expansion for growth when they are confident that an upturn is permanent. 1
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Interest Rate, r Funds, F 0 Supply, the Banks Investment Demand in recession Investment Demand in the upturn r 1 F 1 F 2 In recessions, the expectation is that the Investment Demand curve will be far to the left. Even at low interest rates investors will not want new capital which has a high risk of being idle. In upturns they are willing to expand even if interest rates are rising because expected revenues are also rising and there is some competitive impetus to retain market share. This means that more than one level of borrowing is associated with the same interest rate, and it may be difficult to predict exactly where the investment demand curve may be at any given time since this depends on how the investors themselves view their business prospects. The alternate view is the investors remain relatively sensitive to the cost of borrowed funds over the course of the business cycle. Long-run capital acquisition plans do not change much in response to business conditions unless the change in business conditions is very drastic. The investment demand curve does not shift routinely and when it does shift it does not shift by very much. Interest rates are therefore reliable indicators of prospective investment expenditures.
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