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Is any road construction going on near you? Think about all of
those huge dump trucks and other heavy machinery used in
road construction. Have you ever considered that you may own
part of that machinery? It is true! If you have any money in a
savings account somewhere, your money could be at work on
that construction project. While we don’t recommend trying to tell
the construction workers how to do their job or to speed up their
project, it is interesting to consider how your money is working to
improve your community. If you put your money in a bank
savings account, it becomes available for banks to loan out as
we have already discussed. A business may want to borrow
money to build a factory or purchase new machinery or the
government may need to borrow money to fund spending
projects. Each of these transactions would occur in the loanable
funds market. The loanable funds market is where investment
spending and public and private saving come together. So, the
next time you spot a construction project in progress, consider
how your money may be at work.
Changes in demand for loanable funds come from borrowing by businesses,
consumers, and the government as well as an increase in aggregate income (Y) in the
economy. When financial investors cash in investment holdings, their actions also
increase the demand for loanable funds. The supply of loanable funds comes from or by
an increases in business and consumer savings or from increases in the money supply
as a result of monetary policy (which we will study in Unit 6).
We can graphically show the impact of the change in the supply of or demand for
loanable funds using a loanable funds graph. The loanable funds graph shows the
relationship between real interest rates and the quantity of loanable funds in the money
supply. Businesses (and the federal government) are always looking for the lowest price
or interest rate when they want to borrow money. Lower interest rates generally lead to
a higher quantity of investment spending. Higher interest rates generally mean a lower
quantity of investment spending. Don’t confuse investment spending with investment.
Investment spending is borrowing money, hopefully at the lowest interest rates.
Financial investment is buying securities, bonds, or other financial assets with hopes of
making a high return on your investment.
The quantity of investment spending is not dictated by interest rates alone. The
investment demand curve shows the relationship between interest rates and investment
A shift in the investment demand curve can be caused by a change in the expected rate
of return on capital investment. If businesses expect a higher rate of return on a project,
then the investment demand curve shifts to the right, and businesses will be more
willing to borrow loanable funds at a higher interest rate. If the expected rate of return is
low, then there will be a decrease in demand for investment at every interest rate.
The only exception to this rule is when we talk about financial capital, as we did in Unit
Four. In that case, foreign investors would look for the highest interest rates to get a
better rate of return on their financial (money) investments. Before we move on, you
must first understand the difference between nominal and real interest rates.
Nominal interest rate refers to the current interest rate without adjusting it for inflation
over time. If inflation increases, nominal interest rates increase. If inflation decreases,
nominal interest rates decrease. Real interest rate, on the other hand, refers to interest
rates that are adjusted for inflation.
Real Interest Rates = Nominal Interest Rates – Inflation
For example, suppose you took out a $500 loan to start up a lawn mowing business.
The interest rate on the loan is 10% and inflation is 10%. When you pay back the loan
next year, you must pay back $550. But remember how inflation works. If we adjust the
nominal interest rate for inflation, then the real interest rate is really 0%. (Real Interest
Rate = 10% Nominal Interest Rate – 10% Inflation.) That means that you would be
paying back money that had the same value that you borrowed and the bank would be
losing the $50 in value it earned in interest, because it could not buy as much today as it
could when it loaned the money out.
Careful when you are determining nominal and real interest rates. If we are looking for
nominal interest rates, add the anticipated inflation from real interest rates. If real
interest rates were 10% in the exam above and inflation was 10%, then nominal interest
rates would be 20%. This is an alternate way of looking at real and nominal interest
Closely study the loanable funds graph as you may be required to draw it on the AP
This is a loanable funds graph. This graph is used to show real interest rates. It is a
basic supply and demand graph for the amount of loanable funds available in the
economy. Real interest rates are read from the vertical axis and the quantity of loanable
funds is read from the horizontal axis. Real interest rates are abbreviated with a small
cursive to differentiate them from nominal interest rates. If a question addresses fiscal
policy, use the loanable funds graph to address changes in interest rates.
Click the start button (right pointing triangle) below the graph to learn more.
Changes in the government’s demand for money can have unintended consequences. If
Congress is trying to correct a recession in the economy, it would enact expansionary fiscal
policy. That means it would increase spending or reduce personal income taxes. When the
policy is enacted, the government’s demand for loanable funds would increase. An increase in
demand for loanable funds will increase the interest rates as shown
When interest rates increase, investors find borrowing less desirable. As a result, they
will quit borrowing money and investment spending decreases. If Congress is using
expansionary policy, the decrease in investment spending makes the policy less
effective as private investment is crowded out by the increased interest rates.
Conversely, if Congress uses contractionary policy, private investment would be
encouraged, as interest rates would decrease. In other words, private investment would
be crowded in by the change in interest rates, causing contractionary policy to be less
effective than Congress would desire.
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