11-3-11

• Savers and borrowers care about the real interest rate because tat is what they earn or pay interest after inflation.
• Real interest rate = interest rate - expected inflation
• If expected inflation is 0%; then real rate = nominal rate.
• But its also true that if expected inflation is constant and any change in the nominal rate will be reflected in an identical change in the real rate.
• This is why the graphs in the text are labeled "nominal interest rate for a given expected future inflation rate"

EQUILIBRIUM IN THE LOANABLE FUNDS MARKET
• Demand is downward sloping for one very intuitive reason.
• Firms borrow tot pay for capital investment projects.
• If the project has an expected rate of return that exceeds the real interest rate, the investment will be profitable, and the funds will be demanded.

• Rate of return (%) =
(100(Revenue form project) - (cost of project))-(cost of project)
• As the real rate falls more projects become profitable, so the quantity of funds demanded will increase.

• Supply is upward sloping
• Savers can lend their money to borrowers but in doing so must forgo consumption
• In order to compensate for the forgone consumption, savers must receive interest income and as the real interest rate rises, the opportunity to earn more income rises so more dollars will be saved.
• As the real Rate rises, the quantity of funds supplied will increase.

• Changes in Perceived business opportunities
- A change in the beliefs about the rate of return on investment spending can
increase or reduce the amount of desired spending at any given interest rate.
• Changes in the Government's Borrowing.

• Changes in the government's borrowing
- Budget deficits are major sources of the demand for loanable funds
- Treasury must borrow funds and acquire more debt. This increases the demand
for lovable funds in the market.
- In a budget surplus, less debt would be acquired and the demand for loanable
funds would decrease.

• Changes in private savings behavior
- If households decide to consume more and save less, The supply of loanable funds will shift to the left,
• Changes in capital inflows
- If a nation is perceived to have a stable government, a strong economy and is a
good place to save money, foreign money will flow into that nation's financial
markets, increasing the supply of loanable funds.
INFLATION AND INTEREST RATES
• Anything that shifts either the supply of loanable funds curve or the demand for the loanable funds curve, changes the interest rate.
• We have seen in previous modules that unexpected inflation creates winners and losers, particularly in borrowers and lenders.

• Economists are going to capture the effects of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate where the difference is as follows
Real interest rate = Nominal interest rate - Inflation rate
• For borrowers, the true cost of borrowing is the real interest rate, not the nominal interest rate.
• For lenders, the true payoff to lending is the real interest rate, not the nominal interest rate.