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The Financial System

Market for Loanable Funds


Market for Loanable Funds

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So the financial system is a wide array of markets where you can buy stocks, bonds, and all sorts of other investments as well. However, let's simplify the financial system and just say that there's one investment here, There's one product and that's just low nable funds, Right? So there's gonna be a supply of low noble funds and the demand for low nable funds. Okay, so let's check out this market for low nable funds in this simplified example of the financial system. So obviously the real financial system has a whole bunch of different products. But if we simplify it here as an introduction, we can kind of see how the supply and demand for low noble funds uh interact. So when we say about low nable funds, right? This low nable funds, what is a loan fund? Well, that's money that can be loaned, right? Money that's available to be either borrowed or loaned out. Right. So when we talk about low nable funds, this is income that households have chosen to save rather than spend on consumption. Right? So the low nable funds that are available are those savings of the household. So just like any market, we're gonna have supply demand, we're gonna have a price, an equilibrium price and equilibrium quantity. So what are those in this case? When we talk about low noble funds? Well, just like we said, the supply is those household savings, Whoops. So when the households save money, that money is available to be borrowed, right? It's in the bank account and the bank can loan it out to a firm. So the demand is going to be firms, investment firm investment is going to be the demand for low noble funds. Right? The firms want to borrow money so that they can expand their business. They can buy new machinery, they can buy new factories, whatever it might be. That's gonna be the demand for low nable funds. Now, what's gonna be the price? What what gives you the incentive to save more money or what gives the firm's a reason to want to demand more more funds to borrow. It's going to be the interest rate, it's going to be the interest rate. Right? Think about it. If there was a really high interest rate, you might be incentivized to say, actually, I'm gonna put more money in the bank because I'm gonna get in a lot of interest where a firm might wanna really low interest rate they want to borrow for as cheaply as possible. So, let's go ahead and take this onto the graph. The old graph. Our good buddy here, the price quantity graph. Right? Our price and quantity, Right? But instead of price in this case, I'm gonna change it to interest rate. Okay, So the price in this case is the interest rate. That's the the price of saving money or borrowing money. And when we think about quantity, well, that's the quantity of funds available. Right? So let's start with the supply and just like we would expect with the supply curve, the higher the interest rate, the more quantity of funds are going to be available because more people are gonna be saving. So we would expect that at a low interest rate. Something down here, there wouldn't be many funds available. But as we start to increase the interest rate the funds available are gonna increase just like we would expect with a supply curve, right, supply of low noble funds. And what do you think about that demand curve? That double d downward demand curve? Well, guess what? The same thing follows here at a high interest rate. Well, we're not gonna want to borrow funds as a firm. We're gonna say man, that interest rates really high, we're not gonna be able to make any money, We need to cover that interest. But as that interest gets lower, right? As the interest gets lower, they're gonna demand more funds. So at this very low interest rate down here, there's a high demand for these funds, but a low supply for the funds. So, guess what happens, we reach an equilibrium just like we do in any other market. So we're gonna have this equilibrium right here in the middle and we're gonna have the equilibrium interest rate. So we'll have I'll say I I'll do I'll do our for rate our star is going to be our equilibrium rate. And then we're gonna have our equilibrium quantity Q. Star. So that's the equilibrium quantity of funds as well. And guess what? Just like with any supply and demand, those curves can shift, there's things that can increase the demand for low nable funds, uh increase the supply, right? Those just like we practiced with supply and demand. Those lines can shift as well. So when we think about just like just like what we just discussed, let's go ahead and summarize it here. So the firm's compare the rate of return of a new project when they're thinking of making an investment. Hey, I'm gonna build this factory. How much money can it make? Oh well the investment can make me 10% per year if I build this factory. So should they build the factory? Well that depends on the rate that they're gonna borrow right? If it if they can make 10% on their investment, say 10% is right here And then the rate to borrow is here at 6%. Well they're gonna want to make that investment right? That the they're able to make money on on the borrowing. They will only have to pay back 6% interest while they're making 10% at the factory. Well that would make a sound investment for them, right? So you can imagine as the as the equilibrium rate, excuse me, as the equilibrium rate gets lower. Well that gives firms more opportunities to invest, right? So lower rates the demand is naturally going to increase and that's what we see happening right at this low rate down here, look at how high the demand is out here, right? There's a very high demand at a low rate. So lower rates lead to more investment demand, because now let's say, Okay, so in that example, let's say this rate down here 2%. Well, now now a project that makes 3% looks enticing, right? If there is a project right here that looks enticing because it can cover the interest. However, at our equilibrium that we've been discussing of 6%,, right, you would not want to fund this project because you're gonna have to pay 6% interest when you're only making 3%. Alright, So that's the whole idea that of how the demand curve works for the firms here and just like the household they have the incentive to save at higher interest rates, right? They're gonna save based on the reward that they can get for saving, right? They're gonna receive a reward which in this case is interest, Right? That's the that's the whole reason you would save if you weren't gonna get any interest. Well, you might as well spend that money now um or or else it's gonna lose value to inflation or whatever that might be. Right? So the whole idea here is interest. Uh and just like we see here, and logically follows as the interest rate gets higher, Well, there's gonna be more supply of these funds because there's more and more household savings. So the quantity available goes up as the interest rate goes up. Cool. So notice the same thing at lower rates, the supply of funds naturally decreases because there's a less, it's less rewarding to save. Right? You can't get as much interest. Well, you're less likely to save. So one last thing about this, uh This graph here is the interest rate we've at this point, we just said interest rate. What interest rates are we talking about? Well, remember we've discussed nominal interest rates and real interest rates. The nominal rate is the stated rate of interest. So if I were to give you a loan and I say, Hey, you have to pay me 6% interest, well, that would be the nominal rate. However, we always have to adjust for inflation in this class. Right. There's the real interest rate and that's the nominal rate adjusted for inflation. Right. And we've discussed the nominal and real interest rates and other videos. You can type that in the search bar and get way more information about it. So the whole idea here is that both the savers and the investors, Well, they're the same. The household and the firms are both concerned with inflation. Right, inflation is a big part of this whole uh market. So the equilibrium rate is always gonna be the real interest rate. All right, put it down here. The real interest rate is always going to be the equilibrium rate because that's the rate they care about their going to adjust for inflation, and that's the equilibrium that we reach on this graph up here. Okay, so this equilibrium, and I'll write it in here now. Real interest rate is our price in this market. Cool. Alright, let's pause here, and let's move on to the next video.