Question

Compare and contrast the Bond Market and the Market for Loanable Funds

Answer 1

The bond market and loanable funds market can be examined simultaneously since they are equivalent. Rather then putting both price and interest rates on both graphs so that each has two vertical axes as we did before, now we will separate them. We will measure the price of bonds in the bond market and the interest rate in the loanable funds market. The interest rate is the price charged for the use of loanable funds. For notation, let LF = the quantity of loanable funds.

Changes in Financial MarketsWith this model, we can analyze the effects of many changes in financial markets. Any factor which influences the determinants of bond demand or bond supply that we discussed earlier will affect this model. Two changes that we can describe are an increase in household wealth, and the Fisher effect. The Fisher effect, named for the same Irving Fisher as the Fisher equation, analyzes the effects of an increase in expected inflation.An increase in household wealthAn increase in household wealth, say due to increases in stock or housing prices, will increase the demand for bonds and increase the supply of loanable funds.

The Fisher Effect

Fisher effect:the effects of an increase in expected inflation among investors and borrowers on the bond and loanable funds markets. An increase in expected inflation leads to an increase in nominal interest rates.An increase in the expected rate of inflation influences both the demand and the supply sides of the markets. First, an increase in expected inflation means that expected real interest rates decline. Investors will be less willing to purchase bonds, since their expected real return is less. The decrease in the demand for bonds means a decline in the supply of loanable funds.When expected inflation increases for borrowers, the anticipated real cost of borrowing declines. So firms and governments want to borrow more, and the supply of bonds increases. The increase in the supply of bonds is the same as an increase in the demand for loanable funds.