Finance, Saving, Investment Financial Institutions and Markets ...
Chapter 23 – Finance, Saving, Investment Financial Institutions and Markets channels through which saving flows to finance investment in new capital that grows the economy Finance vs. Money Finance: providing the funds that finance expenditures on capital. The study of finance looks at how households and firms obtain and use financial resources, how they cope with the risks Money: used to pay for goods& services and FoP and to make financial transactions; how we use it, how much we hold, how banks create and manage it, and how its quantity influences the economy. Physical capital vs. financial capital Physical capital: items produced in the past and are used to produce goods/services. Inventories of raw materials, semi-finished goods, and components are part of physical capital Financial capital: funds that firms use to buy physical capital Along the aggregate production function, the quantity of capital is fixed. An increase in the quantity of capital increases production possibilities and shifts the function upward. Capital and Investment Investment increases the quantity of capital; depreciation decreases the quantity of capital Gross investment: total amount spent on new capital and on replacing depreciated capital Net investment: change in value of capital = gross investment – depreciation Wealth and saving Wealth: value of all things that people own; related to what they earn (income: amount received during a given time period from supplying the services of the resources they own) - Increases when market value of assets rises (capital gains) and vice versa (capital losses) Saving: income not paid in taxes or spent on consumption goods/ services. Saving increases wealth. National wealth: wealth at start year + saving during the year = income – consumption expenditure To make real GDP grow, saving and wealth must be transformed into investment and capital. Financial Institutions Firm that operates on both sides of financial capital markets borrower in one, lender in another. Financial markets are highly competitive because financial institutions stand ready to trade so people with funds to lend and people seeking funds can always find someone with whom to trade 1. Banks: accept deposits and use the funds to buy government bonds and other securities to make loans. Distinguished from other financial institutions because bank deposits are money. 2. Trust and loan companies: similar services to banks. Largest of them are owned by banks. They accept deposits, make personal and mortgage loans, & administer estates, trusts, pension plans. 3. Credit unions& Caisses Populaires: banks owned/controlled by their depositors& borrowers. Regulated by provincial rules, operate only in their provincial boundaries. Large number, small size. 4. Pension funds: receive pension contributions of firms and workers. They buy bonds and stocks that they expect to generate an income that balances risk and return. The income pays pension benefits. Some pension funds invest in mortgage-backed securities. 5. Insurance companies: provide risk-sharing services. Enter into agreements to provide compensation in event of accidents. They receive premiums from customers and make payments against claims. - Use the funds to buy bonds/stocks on which they earn an interest income - Insure corporate bonds and other risky financial assets if a firm cannot meet bond obligations. - Normal times: steady flow of funds from premiums and interest on the financial assets they hold and a steady but smaller flow of funds paying claims. Profit is the gap between the 2 flows. - Unusual times: when large losses are being incurred, they face difficulty meeting obligations.
Solvency vs. Liquidity problems A financial institution’s net worth: total market value of what it has lent minus what it has borrowed. - If positive, the institution is solvent and can remain in business - If negative, it is insolvent and goes out of business. The owners of an insolvent financial institution (usually its stockholders) bear the loss when the assets are sold and debts paid. A financial institution borrows and lends, so its net worth might become negative. To limit that risk, institutions are regulated and a minimum amount of their ending must be backed by their net worth Firm is illiquid if it made long-term loans with borrowed funds and is faced with demand to repay more of what it has borrowed than its available cash. In normal times, an illiquid financial institution can borrow. But if all are short of cash, market for loans among financial institutions dries up. Markets for financial capital Saving is the source of the funds used to finance investment, and these funds are supplied/demanded in 3 types of financial markets 1. Loan markets: bank loans, sometimes in form of outstanding credit card balances - Business often want short-term finance to buy inventories or extend credit to their customers - Households often want finance to purchase big-ticket items - Households also buy new homes (investment) funds usually obtained as a loan secured by a mortgage: legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payments (repayment + interest) 2. Bond markets: bond is a promise to make specified payments on specified dates - Government of Canada issues promises called Treasury bills raise finance by issuing bonds - Buyer of a bond loans to the company and is entitled to payments promised by the bond. When a person buys a new bond, he may hold bond until borrower has repaid, or sell the bond. - The term of a bond might be long or short (decades vs. few months). Firms often issue short term bonds as a way of getting paid for their sales before the buyer is able to pay. - Conventional bonds: promise a stated payment of principal on specific date, + periodic payments (coupon rate) until that date
- Mortgage-backed security: bond entitles its holder to income from a package of mortgages. Mortgage lenders create mortgage backed securities. They make mortgage loans to home buyers, and then create securities that they sell to obtain more funds to make mortgage loans. The holder of a mortgage backed security is entitled to receive payments that derive from the payments received by the mortgage lender from the home buyer/borrower. - Treasury bills (strips): carry no stated coupon rate. Return from buying and holding a Treasury bill derived from difference between price paid to acquire the bond, and the face value (to be received at stated future date). The smaller the price, the larger the return. Strip = principal. - Discount factor = (1/interest rate)period = xperiod payment – discount factor = PV 3. Stock markets: financial market in which shares of stocks of corporations are traded - Stock: certificate of ownership and claim to the firm’s profits - Ownership of the company = entitled to some of its profits
Interest rates and asset prices The interest rate of a financial asset is the interest received expressed as a % of the asset’s price Stocks, bonds, short-term securities and loans are collectively called financial assets Price of an asset and the interest rate of the asset are determined simultaneously Negative relationship between interest rates and asset prices 1. The market interest rate is negatively related to the price of a bond 2. The market interest rate is positively related to the yield on any given bond If interest rate rises, price falls, debts are harder to pay, net worth of financial institution falls insolvency can arise from previously unexpected large rises in the interest rate The higher the interest rate, the smaller the PV of a specific future sum at a specific future date - PV is the amount we need to deposit/lend at interest that will compound to 1000 in a year - PV = FV / [(1 + i) T ] highest price willing to pay now to own future stream of payments. At any price lower than PV, there’s excess D for the asset, driving up the price. Hence, the equilibrium market price will be the PC of the income stream that the asset produces. - FV = PV(1 + i)T Market for Loanable Funds Aggregate of all financial markets where households, firms, G, financial institutions borrow/lend Funds that finance investment 1. Household saving (S) 2. Government budget surplus (T – G) 3. Borrowing from the rest of the world (M – X) Y = C + S + T Household income Y is spent on consumption goods C, saved S, or paid in net taxes T - T = taxes paid minus cash transfers Using Y = C + I + G + X – M, and Y = C + S + T, you can see that I + G + X = M + S + T - I = S + (T – G) + (M – X) Investment is financed by household saving, government budget surplus, and borrowing from the rest of the world National saving NS: sum of private saving S, and government/public saving (T – G) - In the LR, when real GDP = Y*, private saving = Y* - T – C - Public saving = combined budget surpluses of federal, provincial, and municipal governments - NS = Y* - T – C + (T – G) = Y* - C – G save what we don’t consume individually or collectively - National saving (S + (T – G)) and foreign borrowing finance investment - As national income rises, public saving (budget surplus) and private saving (saving function) rise - Desired private saving is the difference between disposable income and desired consumption Real Interest Rate The price in market for loanable funds that achieves equilibrium =real interest rate. In market for loanable funds, the interest rate is an average of the interest rates of different financial securities. Nominal interest rate: number of dollars that a borrower pays and a lender receives in interest in a year, expressed as a % of the number of dollars borrowed and lent Real interest rate: nominal adjusted to remove the effects of inflation on the buying power of money = nominal interest rate – inflation rate - Opportunity cost of borrowing/ loanable funds. The real interest paid on borrowed funds is the opportunity cost of borrowing. The real interest rate forgone when funds are used to buy or invest is the cost of not saving/lending the funds.
Demand for Loanable funds (borrowing; investment) Quantity of loanable funds demanded = total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period 2 things determine investment and the demand for loanable funds to finance it 1. Real interest rate: (cost of borrowing)higher = less demanded movement along the curve 2. Expected profit: firms only invest if they expect a profit shift of the curve - Fewer projects are profitable at a high real interest rate expectations of profit is low - the greater the expected profit from new capital, the greater the investment and demand Demand for loanable funds: relationship between QD loanable funds and real interest rate Business investment is the main item that makes up the demand for loanable funds Supply of Loanable Funds (lending; saving) Quantity supplied = total funds available from private saving, government budget surplus, and international borrowing during a given period saving is the main item for supply Decision to save (and supply) is influenced by: 1. Real interest rate: higher = more supplied movement along the curve 2. Disposable income: income earned minus taxes rise in disposable income increases consumption expenditure (by less than rise in income) and savings shift right 3. Expected future income: higher = smaller saving shift left 4. Wealth: higher = smaller saving shift left 5. Default risk: risk that a loan will not be repaid greater risk = higher interest = smaller supply Supply of loanable funds: relationship between quantity supplied and real interest rate, when all other influences on lending plans remain the same.
Equilibrium in Market for Loanable Funds If QS > QD, borrowers find it easy to get funds, but lenders are unable to lend all the funds they have available. The real interest rate falls until QS = QD If QS < QD, borrowers can’t get funds, but lenders are able to lend all the gunds they have available. So real interest rate rises until QS = QD. Changes in demand & supply: Financial markets are volatile in SR but stable in LR, because of fluctuations in DLF/SLF fluctuate real interest rate and equilibrium and asset prices Increase in D: If firms’ expected profits increase, firms increase planned investment & DLF to finance investment shortage of funds borrowers compete, interest rate rises, lenders increase QS of LF Increase in S: If SLF increases, market is flush with loanable funds. Borrowers find bargains, lenders accept lower interest borrowers find more investment profitable and increase QLF borrowed. LR growth of Demand and Supply: Both demand and supply in the market for LF fluctuate and real interest rises/falls. Both SLF and DLF tend to increase over time On average, they increase at a similar pace, so real interest rate has no trend and fluctuates around a constant average level
Government in the Market for Loanable Funds Government budget surplus (government saving) Increases SLF (PSLF + government budget surplus), contributes to financing investment The real interest rate falls, decreasing household saving and QS of private funds (PSLF). The lower real interest rate increases the DLF investment increases, saving decreases Government budget deficit Increases DLF(PDLF + budget deficit) and competes with businesses for funds Real interest rate rises, increases household saving and QS of private funds (PSLF) finances budget deficit. Higher real interest rate decreases DLF investment decreases, saving increases Crowding-out effect: after expansionary fiscal policy tendency for government budget deficit to raise the real interest rate (appreciation), which decreases investment (private expenditure). The deficit crowds out investment by competing with businesses for scarce financial capital if the borrowing necessary for government’s budget deficit drives up interest rate. - It does not decrease investment by full amount of deficit because the higher real interest rate induces an increase in private saving that partly contributes to financing the deficit. - increase in government spending increases aggregate expenditure by less than the increase in G - fiscal expansion increases deficit, increases equilibrium real interest rate, reduces national saving, investment falls no change in equilibrium GDP complete crowding out - open economy interest rates increase inflow of foreign financial capital QD of Canadian dollar rises appreciation of Canadian dollar & crowding out of net exports Riccardo-Barro effect: government budget has no effect on real interest rate or investment. Taxpayers can see that a budget deficit today (reduction in tax) means future taxes are higher and disposable incomes will be smaller. Hence saving today increases. Private saving and private SLF increase to match the rise in DLF by government. - Government debt = postponed tax liability. Government can borrow at low interest because its debt is considered low risk because it can always raise taxes to repay debt. - Consumes do not feel wealthier due to the increase in government’s current borrowing. - Ricardian equivalence doesn’t hold as it requires awareness of future liability and citizen concern for distant future; increases in government deficit lead to a decrease in national saving.
Global Loanable Funds Market International capital mobility Financial capital is mobile: it moves to the best advantage of lenders and borrowers. brings all real interest rates to equality except for differences in the risk premium Because lenders seek highest real interest rate and borrowers seek the lowest, LF market is global. Funds flow into country in which interest rate is highest, & out of country in which interest is lowest.
When funds leave the country with lowest interest rate, a shortage of funds raises the real interest rate of that country. When funds move into the country with the highest interest rate, a surplus of funds lowers real interest rate of the country equality together Equality of interest rates does not mean that if you calculate the average real interest rate of the countries, you get the same number. You have to compare financial assets of equal risk. Lending is risky because loans may not be repaid, or price of stock/bond might fall. Interest rates include a risk premium (interest on risky loan minus on safe loan) riskier loan =higher interest International borrowing and lending Country’s loanable funds market connects with global market through net exports If country’s net exports are negative (X<M), the rest of the world supplies funds to the country and the QLF in the country is greater than national saving If country’s net exports are positive (X>M), the country is a net supplier of funds to the world and the QLF of the country is less than national saving. (X-M) = (T-G) + (S-I) NX = government sector surplus/deficit + private sector surplus/deficit Demand and Supply in the Global and National Markets Demand and supply in global LF market determines the world equilibrium real interest rate. This makes the DLF = SLF in the world economy. But it does not make the DLF = SLF in national economy. The demand and supply of funds in the national economy determine whether the country is a lender or a borrower with the rest of the world. Global LF market: DLFW = sum of demands in all countries. The SLFW = sum of supplies in all counties. World equilibrium real interest rate makes DLFW = SLFW International borrower: the country that borrows from the rest of the world has DLF part of the world demand. The country’s supply SLFD is part of the world’s supply. If this country were isolated from the global market, the real interest rate would be where SLFD = DLF. But with the global economy, funds would flood into the county because suppliers of LF would seek higher return in the country country faces SLF curve instead, horizontal at world equilibrium real interest rate International lender: when a country lends to the rest of the world, the country’s DLF is part of world demand, and the country’s SLFD is part of the world supply. If isolated from global economy, real interest is where DLF = SLFD. but with the global economy, funds quickly flow out as suppliers of loanable funds seek higher return in other countries. So the country faces SLF instead.
Changes in demand and supply: changes real interest rate. The effect of a change in D or S in a national market depends on the size of the country. - A change in D or S in a small country leaves world interest rate unchanged and changes only the country’s net exports and international borrowing /lending. - A change in D or S in a large country has a significant effect on global D or S, so it changes world interest rate and the country’s net exports and international borrowing/lending. Every country feels some effect of a large country’s change in D or S.
Solvency vs. Liquidity problems A financial institution’s net worth: total market value of what it has lent minus what it has borrowed. - If positive, the institution is solvent and can remain in business - If negative, it is insolvent and goes out of business. The owners of an insolvent financial institution (usually its stockholders) bear the loss when the assets are sold and debts paid. A financial institution borrows and lends, so its net worth might become negative. To limit that risk, institutions are regulated and a minimum amount of their ending must be backed by their net worth Firm is illiquid if it made long-term loans with borrowed funds and is faced with demand to repay more of what it has borrowed than its available cash. In normal times, an illiquid financial institution can borrow. But if all are short of cash, market for loans among financial institutions dries up. Markets for financial capital Saving is the source of the funds used to finance investment, and these funds are supplied/demanded in 3 types of financial markets 1. Loan markets: bank loans, sometimes in form of outstanding credit card balances - Business often want short-term finance to buy inventories or extend credit to their customers - Households often want finance to purchase big-ticket items - Households also buy new homes (investment) funds usually obtained as a loan secured by a mortgage: legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payments (repayment + interest) 2. Bond markets: bond is a promise to make specified payments on specified dates - Government of Canada issues promises called Treasury bills raise finance by issuing bonds - Buyer of a bond loans to the company and is entitled to payments promised by the bond. When a person buys a new bond, he may hold bond until borrower has repaid, or sell the bond. - The term of a bond might be long or short (decades vs. few months). Firms often issue short term bonds as a way of getting paid for their sales before the buyer is able to pay. - Conventional bonds: promise a stated payment of principal on specific date, + periodic payments (coupon rate) until that date
- Mortgage-backed security: bond entitles its holder to income from a package of mortgages. Mortgage lenders create mortgage backed securities. They make mortgage loans to home buyers, and then create securities that they sell to obtain more funds to make mortgage loans. The holder of a mortgage backed security is entitled to receive payments that derive from the payments received by the mortgage lender from the home buyer/borrower. - Treasury bills (strips): carry no stated coupon rate. Return from buying and holding a Treasury bill derived from difference between price paid to acquire the bond, and the face value (to be received at stated future date). The smaller the price, the larger the return. Strip = principal. - Discount factor = (1/interest rate)period = xperiod payment – discount factor = PV 3. Stock markets: financial market in which shares of stocks of corporations are traded - Stock: certificate of ownership and claim to the firm’s profits - Ownership of the company = entitled to some of its profits
Interest rates and asset prices The interest rate of a financial asset is the interest received expressed as a % of the asset’s price Stocks, bonds, short-term securities and loans are collectively called financial assets Price of an asset and the interest rate of the asset are determined simultaneously Negative relationship between interest rates and asset prices 1. The market interest rate is negatively related to the price of a bond 2. The market interest rate is positively related to the yield on any given bond If interest rate rises, price falls, debts are harder to pay, net worth of financial institution falls insolvency can arise from previously unexpected large rises in the interest rate The higher the interest rate, the smaller the PV of a specific future sum at a specific future date - PV is the amount we need to deposit/lend at interest that will compound to 1000 in a year - PV = FV / [(1 + i) T ] highest price willing to pay now to own future stream of payments. At any price lower than PV, there’s excess D for the asset, driving up the price. Hence, the equilibrium market price will be the PC of the income stream that the asset produces. - FV = PV(1 + i)T Market for Loanable Funds Aggregate of all financial markets where households, firms, G, financial institutions borrow/lend Funds that finance investment 1. Household saving (S) 2. Government budget surplus (T – G) 3. Borrowing from the rest of the world (M – X) Y = C + S + T Household income Y is spent on consumption goods C, saved S, or paid in net taxes T - T = taxes paid minus cash transfers Using Y = C + I + G + X – M, and Y = C + S + T, you can see that I + G + X = M + S + T - I = S + (T – G) + (M – X) Investment is financed by household saving, government budget surplus, and borrowing from the rest of the world National saving NS: sum of private saving S, and government/public saving (T – G) - In the LR, when real GDP = Y*, private saving = Y* - T – C - Public saving = combined budget surpluses of federal, provincial, and municipal governments - NS = Y* - T – C + (T – G) = Y* - C – G save what we don’t consume individually or collectively - National saving (S + (T – G)) and foreign borrowing finance investment - As national income rises, public saving (budget surplus) and private saving (saving function) rise - Desired private saving is the difference between disposable income and desired consumption Real Interest Rate The price in market for loanable funds that achieves equilibrium =real interest rate. In market for loanable funds, the interest rate is an average of the interest rates of different financial securities. Nominal interest rate: number of dollars that a borrower pays and a lender receives in interest in a year, expressed as a % of the number of dollars borrowed and lent Real interest rate: nominal adjusted to remove the effects of inflation on the buying power of money = nominal interest rate – inflation rate - Opportunity cost of borrowing/ loanable funds. The real interest paid on borrowed funds is the opportunity cost of borrowing. The real interest rate forgone when funds are used to buy or invest is the cost of not saving/lending the funds.
Demand for Loanable funds (borrowing; investment) Quantity of loanable funds demanded = total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period 2 things determine investment and the demand for loanable funds to finance it 1. Real interest rate: (cost of borrowing)higher = less demanded movement along the curve 2. Expected profit: firms only invest if they expect a profit shift of the curve - Fewer projects are profitable at a high real interest rate expectations of profit is low - the greater the expected profit from new capital, the greater the investment and demand Demand for loanable funds: relationship between QD loanable funds and real interest rate Business investment is the main item that makes up the demand for loanable funds Supply of Loanable Funds (lending; saving) Quantity supplied = total funds available from private saving, government budget surplus, and international borrowing during a given period saving is the main item for supply Decision to save (and supply) is influenced by: 1. Real interest rate: higher = more supplied movement along the curve 2. Disposable income: income earned minus taxes rise in disposable income increases consumption expenditure (by less than rise in income) and savings shift right 3. Expected future income: higher = smaller saving shift left 4. Wealth: higher = smaller saving shift left 5. Default risk: risk that a loan will not be repaid greater risk = higher interest = smaller supply Supply of loanable funds: relationship between quantity supplied and real interest rate, when all other influences on lending plans remain the same.
Equilibrium in Market for Loanable Funds If QS > QD, borrowers find it easy to get funds, but lenders are unable to lend all the funds they have available. The real interest rate falls until QS = QD If QS < QD, borrowers can’t get funds, but lenders are able to lend all the gunds they have available. So real interest rate rises until QS = QD. Changes in demand & supply: Financial markets are volatile in SR but stable in LR, because of fluctuations in DLF/SLF fluctuate real interest rate and equilibrium and asset prices Increase in D: If firms’ expected profits increase, firms increase planned investment & DLF to finance investment shortage of funds borrowers compete, interest rate rises, lenders increase QS of LF Increase in S: If SLF increases, market is flush with loanable funds. Borrowers find bargains, lenders accept lower interest borrowers find more investment profitable and increase QLF borrowed. LR growth of Demand and Supply: Both demand and supply in the market for LF fluctuate and real interest rises/falls. Both SLF and DLF tend to increase over time On average, they increase at a similar pace, so real interest rate has no trend and fluctuates around a constant average level
Government in the Market for Loanable Funds Government budget surplus (government saving) Increases SLF (PSLF + government budget surplus), contributes to financing investment The real interest rate falls, decreasing household saving and QS of private funds (PSLF). The lower real interest rate increases the DLF investment increases, saving decreases Government budget deficit Increases DLF(PDLF + budget deficit) and competes with businesses for funds Real interest rate rises, increases household saving and QS of private funds (PSLF) finances budget deficit. Higher real interest rate decreases DLF investment decreases, saving increases Crowding-out effect: after expansionary fiscal policy tendency for government budget deficit to raise the real interest rate (appreciation), which decreases investment (private expenditure). The deficit crowds out investment by competing with businesses for scarce financial capital if the borrowing necessary for government’s budget deficit drives up interest rate. - It does not decrease investment by full amount of deficit because the higher real interest rate induces an increase in private saving that partly contributes to financing the deficit. - increase in government spending increases aggregate expenditure by less than the increase in G - fiscal expansion increases deficit, increases equilibrium real interest rate, reduces national saving, investment falls no change in equilibrium GDP complete crowding out - open economy interest rates increase inflow of foreign financial capital QD of Canadian dollar rises appreciation of Canadian dollar & crowding out of net exports Riccardo-Barro effect: government budget has no effect on real interest rate or investment. Taxpayers can see that a budget deficit today (reduction in tax) means future taxes are higher and disposable incomes will be smaller. Hence saving today increases. Private saving and private SLF increase to match the rise in DLF by government. - Government debt = postponed tax liability. Government can borrow at low interest because its debt is considered low risk because it can always raise taxes to repay debt. - Consumes do not feel wealthier due to the increase in government’s current borrowing. - Ricardian equivalence doesn’t hold as it requires awareness of future liability and citizen concern for distant future; increases in government deficit lead to a decrease in national saving.
Global Loanable Funds Market International capital mobility Financial capital is mobile: it moves to the best advantage of lenders and borrowers. brings all real interest rates to equality except for differences in the risk premium Because lenders seek highest real interest rate and borrowers seek the lowest, LF market is global. Funds flow into country in which interest rate is highest, & out of country in which interest is lowest.
When funds leave the country with lowest interest rate, a shortage of funds raises the real interest rate of that country. When funds move into the country with the highest interest rate, a surplus of funds lowers real interest rate of the country equality together Equality of interest rates does not mean that if you calculate the average real interest rate of the countries, you get the same number. You have to compare financial assets of equal risk. Lending is risky because loans may not be repaid, or price of stock/bond might fall. Interest rates include a risk premium (interest on risky loan minus on safe loan) riskier loan =higher interest International borrowing and lending Country’s loanable funds market connects with global market through net exports If country’s net exports are negative (X<M), the rest of the world supplies funds to the country and the QLF in the country is greater than national saving If country’s net exports are positive (X>M), the country is a net supplier of funds to the world and the QLF of the country is less than national saving. (X-M) = (T-G) + (S-I) NX = government sector surplus/deficit + private sector surplus/deficit Demand and Supply in the Global and National Markets Demand and supply in global LF market determines the world equilibrium real interest rate. This makes the DLF = SLF in the world economy. But it does not make the DLF = SLF in national economy. The demand and supply of funds in the national economy determine whether the country is a lender or a borrower with the rest of the world. Global LF market: DLFW = sum of demands in all countries. The SLFW = sum of supplies in all counties. World equilibrium real interest rate makes DLFW = SLFW International borrower: the country that borrows from the rest of the world has DLF part of the world demand. The country’s supply SLFD is part of the world’s supply. If this country were isolated from the global market, the real interest rate would be where SLFD = DLF. But with the global economy, funds would flood into the county because suppliers of LF would seek higher return in the country country faces SLF curve instead, horizontal at world equilibrium real interest rate International lender: when a country lends to the rest of the world, the country’s DLF is part of world demand, and the country’s SLFD is part of the world supply. If isolated from global economy, real interest is where DLF = SLFD. but with the global economy, funds quickly flow out as suppliers of loanable funds seek higher return in other countries. So the country faces SLF instead.
Changes in demand and supply: changes real interest rate. The effect of a change in D or S in a national market depends on the size of the country. - A change in D or S in a small country leaves world interest rate unchanged and changes only the country’s net exports and international borrowing /lending. - A change in D or S in a large country has a significant effect on global D or S, so it changes world interest rate and the country’s net exports and international borrowing/lending. Every country feels some effect of a large country’s change in D or S.
