Question

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Suppose the government decided to support savings through tax cuts on retirement funds:

a) Who are the main two agents (suppliers and demanders) in the Loanable Funds Market? Which agent is affected by this new policy?

b) How would this new policy affect the Loanable Funds Market? Describe using supply and demand. What do you think will happen to the total amount saved and invested in this case? Show on a graph.

c) Now suppose you are a policy-maker willing to analyze the effects of this new policy described above. Also suppose you do not know the slope of the demand curve. You also know that there are two options: the demand curve is either relatively elastic or the demand curve is relatively inelastic. Could you show how your analysis would change depending on the slope of the demand curve? Which option would result with a higher quantity invested in the economy due to this new policy?

Answer 1

a) So, let us start by knowing what is the loanable market:

Loanable funds is the total sum of all the money the people in an economy have decided to save up, and lend out to those who need it, instead of using it up for personal consumption. This way of lending money to borrowers and earning interest on it is a type of investment.

So, the main agents, the suppliers of the loanable funds market are the lenders/savers and the demanders of the loanable funds market are the borrowers. Demanders/suppliers of this market could include the same people such as the households, non-financial firms, the financial businesses, government, as well as foreign investors.

This new policy is attempted to increase the savings which is a main factor in creating suppliers of loanable funds. The more the people can save from their income, the more they have money in the hand left to lend out and invest.

b) So, let us see how the tax cuts affect the loanable funds market through its supply and demand: The loanable funds market has a supply curve, demand curve and their intersection gives the equilibrium real interest rate. This the real return of an investment.

We know, National income Y = C+ I + G + NX ,

This is the case of an open economy, where C= consumption spending, I = investment spending, G= government spending and NX = net exports.  

In case of closed economy, NX = 0

Y = C + G + I ,

I = Y - C - G ,

As we know, govt spending is paid from the taxes they collect and thees taxes are deducted from income, also, govt spending is taken out of taxes

So, I = Y - T - C + T - G

I = Y - T -C which is private savings and T-G = public savings ,

I = sum of public and private savings = S

Now, in case its an open economy, simply net capital inflows will be added to the right side of the above equation equation

This clearly shows that with a tax cut, and increase in savings, Investment spending will increase, and

hence, the supply curve will shift to the right. This will increase the supply of loanable funds, and this increase in supply will lead to a lower interest rate. Hence, with the cut in tax rate, the disposable income could increase, i.e. people will have more money in hand to save and invest.

Take a look at fig 1:

In a simple model, we can assume a macroeconomic equilibrium to be at I= S i.e. planned investment = planned savings,

The real rate of interest is the nominal rate minus the inflation rate. It gives us the real return of an investment. It is also considered to be the opportunity cost of consumption,

We can graph the savings and investmet curves just like a supply and demand curve where investment = demand and supply = savings. The intersection of the S and I gives us the equailibrium real rate of interest r.

Flexible real interest rates ensure that whatever happens, savings and investment spending are always equal to each other. In this case, as savings rise, it shows a rightward shift. Then, the equilibrum real interest rate will fall until investment also increase and savings and investment is equal again. Take a look at fig 2:

c) So, let us take a look at fig 3 and 4 showcasing a relatively inelastic and elastic demand curve respectively:

So, in fig 3, we see a relatively inelastic demand curve,

As per its definition, even with a substantial fall in the real interest rate from r1 to r2, there is not much increase in the quantity demanded of loanable funds ie. from Q1 to Q2.  So, as supply of loanable funds would increase and the real interest rate would fall, there would not be much of an increase in the quantity demanded for loans i.e. investement.

Now, in fig 4,

With a relatively elastic demand curve,

we see that even with a small fall in the real interest rate from r1 to r2, there is a higher increase in the quantity demanded of loanable funds ie. from Q1 to Q2. So, as supply of loanable funds would increase, and with the fall of even little amount of real interest rate would increase the quantity demanded for loans and invested amount in the economy much more.

So, if a higher increase in quantity invested in needed, it should be in the case of the second option i.e. a relatively elastic demand curve. In this case, even though the real interest rate would fall, the demand would still be higher and this would result in a higher amount of investment in the economy. ​​​​​​​