Loanable Funds Market Chapter 24. TIPS Bond The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate. Investors.

Loanable Funds Market

• Chapter 24

TIPS Bond

• The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate.

• Investors are paid off in terms of real purchasing power.

• Yield is equivalent to a real interest rate.

Additional Information from U.S. Treasury

Falling Yields

1997 1998 1999 2000 2001 2002 37622 37987 38353 38718 39083 39448 39814 40179 40544 40909 41275

-1

0

1

2

3

4

5

10-Year Treasury Inflation-Indexed Security, Constant Ma-turity (DFII10), Percent, Annual, Not Seasonally Adjusted

Loanable Funds Market• Consider the financial market at its broadest and most abstract. • an amalgamation of the bond market and the lending

market (banks, etc.)• Map the relationship between the real interest rate and the quantity of funds that are lent.• Supply curve represents the behavior of savers & lenders• Demand curve represents the behavior of borrowers

Demand Curve: Loanable Funds• Why does the demand curve slope down?• Firms borrow to finance investment projects. If the return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects are above the hurdle.

• Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.

Supply Curve: Loanable Funds

•Why does the supply curve slope up?Substitution Effect: When real interest rates offered by banks are high, savers are rewarded with more future consumption and are likely to be induced to save more.

Loanable Funds Market

SLFDLF

LF

r

Closed economy equilibrium

• In closed economy, market forces should cause supply and demand for loanable funds to equilibrate at a real interest rate where supply equals demand.

• Shifts in demand or supply change equilibrium real rate as in standard supply-demand model.

Competitive Market Equilibrium:Loanable Funds Market

SLFDLF

LF

r*

LF*

r

Demand for Loanable Funds: Determinants

Private1. Real interest rate – 2. Restrictions (LtV, Collateral

Constraints) Corporate3. Profitability of business

projects +4. Uncertainty of business

investment – 5. Retained earnings – Mortgage Market6. Demand for Housing +

Public1. Government Deficits + 2. Corporate Profits Tax –

Supply of Loanable Funds: Determinants

Private1. Real interest rate +Household2. Disposable Income +3. Expected Future Income – 4. Value of Assets/Wealth – 5. Default Risk – 6. Uncertainty of Future

Income +

Public5. Government Surplus + 6. Interest Income Tax –

Ex. Uncertainty about Future Capital Infrastructure Investment

SLFDLF

LF

r*

LF*

r

r**

DLF'

LF**

1

2

Consumers become more worried about the future.

DLF

LF

r*

LF*

r

LF**

SLF'

r**

1

2

SLF

Government Surplus• Government surplus is gap between govt revenue and outlays

and can be positive or negative.• If net positive, it adds to the supply of loanable funds.• If net negative, it adds to the demand for loanable funds.

IMF Fiscal Monitor

Example: Swiss Government strikes a deal to raise taxes and cut spending

LF

r**

LF*

r

r*

LF**

1

2

DLF SLFP SLF

Example Japan Government runs a deficit to finance infrastructure reinforcement.Budget Plan

LF

r*

LF*

r

r**

LF**

1

2

DLFP DLF SLF

Globalization and the Loanable Funds Market

• OUaT, we might have thought of the loanable funds market as being national in nature – especially for large economies. These days it appears that even the USA is part of a single global market. [China possible exception]

• Otherwise take global interest rate as given.

Dec.1977Jun.1980Dec.1982Jun.1985Dec.1987Jun.1990Dec.1992Jun.1995Dec.1997Jun.2000Dec.2002Jun.2005Dec.2007Jun.20100

5000

10000

15000

20000

25000

30000

35000

40000

45000

Summary of International Posi-tions,

Amount Outstanding (In billions of US dollars)

Tota

l Ass

ets

SOURCE: PRELIMINARY REPORT: 27 JULY 2011, BIS REPORTING BANKS HTTP://WWW.BIS.ORG/STATISTICS/BANKSTATS.HTM

Perspectives on Financial Globalization

Mar.1987

Dec.1987

Sep.1988

Jun.1989

Mar.1990

Dec.1990

Sep.1991

Jun.1992

Mar.1993

Dec.1993

Sep.1994

Jun.1995

Mar.1996

Dec.1996

Sep.1997

Jun.1998

Mar.1999

Dec.1999

Sep.2000

Jun.2001

Mar.2002

Dec.2002

Sep.2003

Jun.2004

Mar.2005

Dec.2005

Sep.2006

Jun.2007

Mar.2008

Dec.2008

Sep.2009

Jun.2010

Mar.2011

0

5000

10000

15000

20000

25000

30000

35000

International debt securities - all issuers

(in billions of US dollars)

SOURCE: BIS QUARTERLY REVIEW: 'JUNE 2011TABLE 12A: INTERNATIONAL DEBT SECURITIES - ALL ISSUERSHTTP://WWW.BIS.ORG/STATISTICS/SECSTATS.HTM

21

Growing Exposure of LT interest rates to global economy

“Monetary Policy in Asia and the Pacific in the Post-Post Crisis Era”, Hiro Ito, Portland State, 2013.

Outline

Competitive Market Equilibrium:World Loanable Funds Market

SLFWDLFW

LFLFW

r

rW

National Loanable Funds Markets in a Global World

• How do national economies relate to the global financial market?

1. Countries will face an external interest rate, rW, unaffected by national savings or investment.

2. International lending (borrowing) will make up the gap between savings and investment.

Competitive Market Equilibrium:Demand exceeds Supply

LF

rW

r

International Borrowing

DLF SLF

Investment Boom Mongolia[r Doesn’t Rise, Gap made up by Capital Inflows]

LF

rW

LF*

r

LF**

12

Borrowing

DLF DLF' SLF

Boomtown Mongolia Financial Times

Competitive Market Equilibrium:Supply exceeds Demand

LF

rW

r

International Lending

DLFSLF

Oil Fields Running at peak, Norway(r does not fall, gap made up by capital outflows)

LF

rW

r

1

2

DLFSLF

Lending

SLF'

Bloomberg Norway Wealth Fund 40% Bonds

Global LF Market• Only very large changes in large countries or international

trends will have an impact on real interest rates.

Savings Glut• Theory put forth by Fed Chairman explaining the U.S.

trade deficit: Washington Post Article

IMF Data Mapper

Growing Gap between savings & investment in Asia

IMF Regional Outlook Asia Pacific 2010

Savings GlutSLFW

DLFW'

LFLFW

r

rW

DLFW

SLFW'

rWW

Global Savings Rises

Global Investment Declines

World Interest Rate Falls(Passive Response Economy)

LF

rW

r

1

2rWW

2

DLF

SLF

International Borrowing

US Current Account

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

NX NFI CA

NOMINAL YIELDSOptional

Ex Ante Rate and the Fisher Effect

1EA FORECAST

t t ti r

• Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

• Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

Great Inflation of the 1970’s

US Inflation Rates & Interest Rates

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

Mar

-55

Mar

-58

Mar

-61

Mar

-64

Mar

-67

Mar

-70

Mar

-73

Mar

-76

Mar

-79

Mar

-82

Mar

-85

Mar

-88

Mar

-91

Mar

-94

Mar

-97

Mar

-00

Mar

-03

%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Great Inflation Download

Fisher Effect: OECD Economies Great Inflation of 1970’s

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18

Average Inflation 1970-1984

Inte

rest

Rat

es-1

984

Loanable Funds MarketFisher Effect

LF

r*

LF*

1Et

1Et

i*

DLFSLF

NDLFNSLF

Learning Outcome

• Use the Loanable Funds model to analyze the effects of events on savings, investment, and real interest rates in capital markets.

• Model Global Loanable Funds market and the determinants of current accounts.

• Use expected inflation and the Fisher effect to determine nominal interest rates.