The Supply of Loanable Funds: A Comment on the Misconception and Its Implications

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1 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte The Supply of Loanable Funds: Comment on the Misconception and Its Implications. Wahhab Khandke and mena Khandke* STRCT Recently Fields-Hat publish two aticles on inteest ate detemination in this jounal. In both aticles, they analyze inteest ates on the basis of an unconventional definition of the supply of loanable funds. In this note we ague that thei concept of the supply of loanable funds based on spillove fom the money maket is a goss misundestanding of the concept. lthough Fields-Hat consideed thei concept as citically impotant pat of thei stoy, the esults in thei fist aticle ae independent of this mistake. Howeve, thei second aticle continues this misconception and hence yields invalid esults. Intoduction Leading intoductoy macoeconomic textbooks typically pesent two appoaches to inteest ate detemination the Liquidity Pefeence (LP) appoach 1 and the Loanable Funds (LF) appoach. 2 In the LP appoach, the equilibium inteest ate is detemined in the money maket whee quantity of money demanded by the people equals the quantity of money supplied by the cental bank. In the LF appoach, the equilibium inteest ate equates the quantity supplied of LF, which consists of saving (s), with the quantity demanded fo LF, which consists of investment (i) and bond financed govenment deficit (g t). It is implicit in the textbooks that both the appoaches lead to the same shot-un and long-un equilibium inteest ates, and the esults ae independent of the choice of appoach. The IS-LM model fo inteest ate detemination is intoduced only in the uppe level textbooks, and is widely used in the fields of applied economics. ut that does not diminish the impotance of LF model. In fact, in the field of public finance, LF model has distinct advantages ove IS-LM model as LF model highlights diect connection between fedeal boowing and inteest ate, wheeas the IS-LM model only shows this connection indiectly. 3 Cebula (1997), Hoelsche (1983, 1986), Koch & Cebula (1994), Thomas & bdeezak (1988), and Tan & Sawhney (1988) ae only a few who used LF model to examine the effects of govenment boowing on shot-un and/o long-un inteest ates. Cebula (1997), Koch & Cebula (1994), and Tan & Sawhney (1988) also used the extended open economy vesion of the LF model whee capital flows ae incopoated in the supply side of the loanable funds. wide application of LF model in applied economics fields emphasizes the impotant of teaching the LF model coectly. Recently Fields and Hat, heeafte F&H, published two aticles in the Jounal of Economics and Finance Education on the modeling of inteest ate detemination. The fist aticle (2003) intoduces an unconventional definition of the supply of LF and concludes that the inteest ate in the immediate-un is detemined eithe in the LF maket o in the money maket, but not both. In othe wods, in the immediateun, if the inteest ate is detemined in the LF maket, then the money maket cannot be in equilibium. Howeve, if the inteest ate equilibates the money maket, the LF maket will no longe be in equilibium in the immediate-un. Hee, the immediate-un is defined as a situation whee eithe the money o the LF (goods) maket is in equilibium at constant output. In both the aticles, F&H efe to this situation as *. Wahhab Khandke, Pofesso of Economics, Univesity of Wisconsin-La Cosse, La Cosse, WI 54601, mena Khandke, Senio Lectue of Economics, Univesity of Wisconsin-La Cosse, La Cosse, WI 54601, We would like to thank Pofessos Richad Cebula, Keith Sheony and two anonymous efeees fo thei valuable comments on an ealie daft. 1 lso known as the Keynesian theoy of inteest ate detemination 2 lso known as the classical theoy of inteest ate detemination 3 Hoelsche (1983), p. 321

2 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte shot-un. It is impotant to note that F&H definition of shot-un is diffeent fom that of a standad textbook definition, which necessitates the intoduction of the concept immediate-un. In thei second aticle, F&H (2005) intoduce a constant-pice IS-LM-LFM model in esponse to the Yang and Yanochik (2005) aticle that emphasizes a constant-pice IS-LM model fo shot-un 4 inteest ate detemination. They also eaffim thei pevious esults of immediate-un inteest ate detemination. Moe significantly, howeve, the F&H (2005) aticle explains thei pefeence fo the LF appoach ove the LP appoach with the notion that the spillove fom the money maket geneates a LF maket sepaate fom the goods maket. In this pape, we begin with the F&H (2003) depiction of the supply of LF. We identify an eo in thei epesentation of the supply of LF, and demonstate that when thei misconception of the supply of LF is coected, no distinction between the goods and the LF makets exists. The implications of coecting this misconception ae then addessed by eexamining the thee policy shocks F&H (2005) consideed. Supply of Loanable Funds ccoding to F&H When analyzing the immediate-un inteest ate, F&H (2003) begin with standad textbook figues of the LP and the LF appoaches. Following Gwatney, Stoup, Sobel, and Macpheson (2003), they pesent figues of these two appoaches side by side to make the compaison easy to undestand. To captue thei undestanding of the supply of LF though spillove fom the money maket, we pesent the LP appoach in Figue 1 whee the eal money supply, M/P, is independent of the inteest ate and, hence, is vetical. In contast, eal money demand, k().y, 5 is a downwad sloping cuve epesenting the fact that the quantity of eal money balance demanded ises as the oppotunity cost of holding money falls. M/P s(y * ) LF S = s(y * ) + [M/P * k().y * i() + (g t) Quantity of LF 1 Quantity of Loanable Figue 1 Figue 2 The LF appoach is depicted in Figue 2. In the classical model, saving is taken to be a positive function of the inteest ate. Fo simplicity, F&H (2003) assume that saving, s, depends only on income and not on the inteest ate. s a esult, the saving function is a vetical line denoted by s(y)* in Figue 2. lgebaically, they fomulate the supply of LF cuve as LF S = s + [M/P k().y] whee [M/P k().y] is the quantity of excess money supplied at a given inteest ate. t 0 in Figue 1, the quantity of eal money demanded is the same as the quantity of eal money supplied, which makes excess quantity of money supplied equal to zeo. 4 Shot-un is defined as a situation whee both the goods and the money makets ae in equilibium 5 F&H s chosen epesentation of the eal money demand is: m d = m d (, y). We pefe to wite eal money demand as k().y following the evised quantity theoy of money.

3 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte The quantity of LF supplied in this case is the same as the amount of saving (see Figue 2). t a highe inteest ate, 2, the quantity of excess money supplied is positive. ccoding to F&H (2003), this amount spills ove into the LF maket inceasing the quantity of LF supplied by the amount of the excess money supply. In thei wods: Theefoe, absent any spillove fom the money maket, the supply of loanable funds would be the (dashed) vetical line at LF 1, denoted s. Howeve, the supply of loanable funds, ---- is upwad sloping when plotted against the inteest ate. The eason is that a (ceteis paibus) incease in the inteest ate esults in an excess supply in the money maket that spills ove into the maket fo loanable funds. The esult is an incease in the loanable funds supplied as the inteest ate inceases. Similaly, a decease in the inteest ate lowes the quantity of loanable funds supplied as economic agents attempt to build up thei eal money balance. 6 s the inteest ate ises fom 0 to 2, the quantity of excess money supplied is equal to the distance (Figue 1). ccoding to F&H (2003), this quantity epesented by the distance will spillove into the LF maket inceasing its quantity supplied of LF by the same amount; theeby, esulting in an upwad sloping supply of LF cuve. Misconception about the Supply of Loanable Funds Saving, which classical economists call the supply of LF, povides the demand fo bonds. Saving is the amount of foegone cuent consumption fo futue consumption. Saves ean inteest etuns fom bonds, which give them geate command ove futue consumption. ut all saving need not go into bonds; saving is also held in the fom of money. Since money does not ean inteest, classical economists assume that saves will pefe bonds ove money. Howeve, people also hold some money as it povides liquidity and secuity. In othe wods, people usually save in two diffeent foms bonds and money, both of which ae channeled into the supply of LF eithe diectly though bonds maket o indiectly though lending institutions. Mankiw (2007) 7 explains it eloquently: The supply of loanable funds comes fom people who have some exta income they want to save and lend out. This lending can occu diectly, such as when a household buys a bond fom a fim, o it can occu indiectly, such as when a household makes a deposit in a bank, which in tun uses the funds to make loans. In both cases, saving is the souce of the supply of loanable funds. The composition of the supply of LF is detemined by the inteest ate. t a highe inteest ate, people will hold moe bonds and less money. The majo misundestanding on F&H s pat is not to ealize that as the inteest ate inceases people only change the composition of thei saving (ceteis paibus), and not the absolute amount of saving when saving depends only on income. Consequently, the saving function will still be equal to the supply of LF at all levels of inteest ates. We elaboate this point futhe in Figue 3 and 4. Saving is defined as the pat of disposable income that is not consumed, and people allocate it between money (non inteest-beaing assets) and bonds (inteest-beaing assets). t the equilibium inteest ate 0, people demand M/P quantity of money, which is the entie amount of money supplied as shown in Figue 3. Howeve, this is only one pat of saving because people also hold some bonds at this inteest ate. Suppose at inteest ate 0, the total value of bonds held by saves is 0, so that the amount of saving at 0 is s 0 = M/P + 0. n incease in the inteest ate fom 0 to 2 inceases the oppotunity cost of holding money. Figue 3 shows that saves educe thei quantity of money holdings by the amount of the distance, and use that quantity of money to buy bonds. F&H (2003) explain how an incease in the inteest ate esults in an excess supply in the money maket that spills ove into the maket fo loanable funds, theeby inceasing the supply of LF. In eality, a change in the inteest ate changes only the composition of inteest-beaing and non inteest-beaing asset holdings, which keeps the quantity of saving, and by extension, the quantity of loanable funds supplied constant at s (y) in Figue 4. In othe wods, an incease in the inteest ate esults not in a spillove into the maket fo loanable funds but a spillove fom money holding to bond holding within the supply of LF. The logic is as follows: since saving, s, does not depend on inteest ate, a highe inteest ate does not change the amount of saving and, hence, consumption. Given income at the potential level (y*), consumption and saving cannot change due to a highe inteest ate because they depend only on income. The quantity of LF cannot incease unless saving inceases, i.e. 6 F&H (2003), p. 9 7 Mankiw (2007), p. 208

4 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte consumption deceases fo the same level of income. This confims that saving is the only souce of the supply of LF depicted in Figue 4. M/P LF S = s(y * ) C 0 C k().y * i() + (g t) Quantity of LF 1 Quantity of Figue3 Figue4 Implications of the Misconception F&H (2003) conclude that in the immediate-un, the inteest ate can clea eithe the money maket o the LF maket and cannot simultaneously clea both the makets when the economy is out of equilibium. lthough F&H (2003) eed in defining the supply of LF, thei main esults emain valid with mino changes in the exposition. Howeve, this is not the case with thei second aticle. In a eply to the Yang and Yanochik (2005) aticle that emphasizes the constant-pice IS-LM model, F&H (2005) intoduce a constant-pice IS-LM-LFM model fo both shot-un and immediate-un inteest ate detemination. Thei LFM cuve is unconventional and needs elaboation. F&H (2005) use the standad IS and LM cuves to epesent goods and money makets equilibium combinations of output and inteest ate. Howeve thei LFM epesents a thid maket that they call the maket fo loanable funds. Equilibium in this maket occus when the supply of loanable funds, LF S {i.e., desied saving, s(y - t), plus the excess supply of money, [m S 1 - m d (y, )]}, equals the demand fo loanable funds, LF d [i.e., investment, i(), plus the bond financed govenment deficit, (g - t)]. lgebaically, this equilibium condition is: s(y - t) + [m S 1 - m d (y, )] = i() + [g - t]. 8 This equation detemines thei LFM cuve. When the definition of the supply of LF is coected whee s(y) is the only souce of the supply of LF, the equilibium condition in the LF maket educes to: s(y - t) = i() + [g - t]. Substituting the value of s(y - t) 9 with y c(y t), we get y c(y t) = i() + [g t] o y = c(y t) + i() + [g t], which is the same as the goods maket equilibium condition (the IS cuve). 10 In eality, F&H s (2005) LFM cuve coincides with the IS cuve which means the goods maket can also be efeed to as the LF maket. 8 F&H (2005), p Saving s(y) is defined as the amount of output (y) ove consumption c(y t) 10 F&H (2005) also ecognizes this fact, p. 13 footnote.

5 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte Implications of Coecting the Misconception Ou finding equies a eexamination of the F&H (2005) esults. Following F&H (2005), we conside the effects of thee policy shocks: (1) an incease in the money supply; (2) a bond-financed ise in govenment expenditues; and (3) a money-financed ise in govenment expenditues. n Incease in the Money Supply F&H (2005) conclude that the immediate-un impact of an incease in the money supply is a decease in the inteest ate (). Howeve, has to decease moe to clea the money maket than to clea the LF maket. We show that has to decease to clea the money maket but the LF maket will still be in equilibium at the oiginal inteest ate. We stat with an initial shot-un equilibium at point in Figue 5 whee the inteest ate is 3 and output is y*. n incease in the nominal money supply fom M to M 2 will incease the eal money supply fom M/P to M 2 /P. This incease in money supply will shift the LM cuve ight to LM 2 leaving the IS (LFM) cuve unaffected. The new shot-un equilibium is at point D whee the LM 2 and the IS cuves intesect. In the immediate-un (the vetical shift in the LM cuve) epesents the amount the inteest ate must fall to estoe equilibium in the money maket. In Figue 5, immediate-un money maket equilibium is attained at 0. Howeve, contay to the F&H (2005) conclusion, since the LF maket (i.e. goods maket) is independent of the incease in eal money supply in the immediate-un, the inteest ate 3 will still clea the LF maket at point. L LM D IS = y* Figue 5 Output ond-financed Rise in g F&H (2005) show that a bond-financed ise in g inceases in the immediate-un. Howeve, if adjusts to clea the goods maket, the inteest ate ises moe than if cleas the LF maket. Thei esults ae coect to the extent that has to incease to clea the makets. Howeve, since we have poven that thee is no distinction between the goods maket and the LF maket, the question of two diffeent inteest ates does not aise. We use Figue 6 to pove this point. We stat with a shot-un equilibium at point whee inteest ate is 3 and output is y*. n incease in g shifts the IS cuve ightwad to IS 2 leaving the LM cuve unaffected, and the new shot-un equilibium position is at point D. In this case, the distance epesents the amount the inteest ate must ise to estoe immediate-un equilibium in the LF (goods) maket.

6 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte LM D IS = LFM IS 2 = LFM 2 y* Output Figue 6 Money-Financed Rise in g Finally, a money-financed incease in govenment expenditues calls fo an incease in the inteest ate to estoe immediate-un equilibium in the LF (goods) maket but a decease in the inteest ate to estoe equilibium in the money maket. This invalidates F&H (2005) conclusion of no change in inteest ate in the immediate-un if it is detemined in the LF maket. This is shown in Figue 7 whee the initial shot-un equilibium is at point whee the inteest ate is 3, and output is y*. ise in govenment expenditues fom g to g 2 financed by an incease in the eal money supply will shift both the IS and LM cuves to the ight. The shot-un equilibium inteest ate can be highe o lowe than initial inteest ate 3 as ecognized by F&H (2005). The vetical shifts in the IS and LM cuves detemine the change in the inteest ate unde altenative appoaches to inteest ate detemination. If the inteest ate adjusts to clea the money maket, then the inteest ate deceases fom 3 to 0 (point to point C). ut if it adjusts to clea the LF (goods) maket, the immediate-un impact will be an incease in the inteest ate fom 3 to 6 (point to point ). Conclusion F&H (2003) intoduce an unconventional definition and appoach to supply of loanable funds detemination. This pape identifies an eo in thei appoach, theeby eestablishing the conventional definition of the supply of loanable funds. Moe significantly, this pape shows that the LFM cuve of thei IS-LM-LFM model coincides with the taditional IS cuve when the coect supply of loanable funds concept is applied. s a esult, the equilibium condition of the maket fo loanable funds educes to that of the goods maket equilibium condition. Recognition of this symmety necessitates evision of the F&H (2005) esults. These include: 1. n incease in money supply has no effect on the loanable funds maket in the immediate-un. 2. bond-financed ise in govenment expenditues does not equie two diffeent inteest ates to equilibate the goods and the loanable funds makets in the immediate-un as the two makets ae synonymous. 3. money-financed incease in govenment expenditues does not leave the inteest ate unchanged in the immediate-un if it is detemined in the maket fo loanable funds. The inteest ate has to ise to clea the loanable funds maket.

7 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte LM 6 LM 2 3 D 0 C IS = LFM IS 2 = LFM 2 y* Figue 7 Output So fa as the choice of the appoach is concened, F&H (2005) conclude: With the exception of a joint eal-financial shock, the diection of the patial equilibium impact on is the same in both the Liquidity Pefeence and Loanable Funds appoaches to inteest ate detemination. The magnitude of the impact on does, howeve, diffe in the two appoaches. In paticula, the Loanable Funds appoach esults in smalle fluctuations in the inteest ate. Howeve, when thee is a joint ealfinancial shock, even the diection of the inteest ate esponse is open to question in the appoach suggested by Y&Y. Howeve thei agument collapses when thee is no spillove fom the money maket, which we have poven to be the case. We agee with F&H (2005) that jumping back and foth between the liquidity pefeence and loanable funds appoaches in the immediate-un depending on the oigin of the distubance is not a good ecipe fo developing a coheent undestanding of inteest ate detemination. Ou suggestion is to maintain the status quo, whee the shot-un inteest ate is jointly detemined by the two appoaches while the long-un inteest ate is detemined by the loanable funds appoach. Choosing one appoach ove anothe fo immediate-un inteest ate detemination does not move us fowad as it fails to answe the question: what happens to the inteest ate in the eal wold when a ise in govenment expenditues is financed by an incease in money supply? To us, the diection of the inteest ate movement due to an extenal shock to both IS and LM cuves can sometimes be unpedictable in the immediate-un, but the dynamics of the shot-un adjustment mechanism will soon stat taking place. The inteest ate will move towad the shot-un equilibium, and we do not need to choose between appoaches any moe. Refeences Cebula, Richad R n empiical Note on the Impact of the Fedeal udget Deficit on Ex nti Real Long-Tem Inteest Rates, Southen Economic Jounal. Vol. 63 (No 4). pil Fields, T. Windso and William R. Hat What We Should (Not) Teach Students bout Inteest Rate Detemination. Jounal of Economics and Finance Education, Vol. 2 (No. 2). Winte Fields, T. Windso and William R. Hat dditional Thoughts on the Detemination of Inteest Rates in Geneal and Patial Equilibium. Jounal of Economics and Finance Education. Vol. 4 (No. 1). Summe

8 JOURNL OF ECONOMICS ND FINNCE EDUCTION Volume 7 Numbe 2 Winte Gwatney, James D., Richad N. Stoup, Russell S. Sobel, and David. Macpheson Macoeconomics: Pivate and Public Choice, 10 th ed. Olando: The Dyden Pess. Hoelsche, Gegoy P "Fedeal oowing and Shot Tem Inteest Rates." Southen Economic Jounal. Octobe Hoelsche, Gegoy P "New Evidence on Deficits and Inteest Rates." Jounal of Money, Cedit and anking. Febuay Koch, James V. and Richad J. Cebula "Fedeal udget Deficits, Inteest Rates, and Capital Flows: Note." Quately Review of Economics and Finance. Sping Mankiw, N. Gegoy Pinciples of Macoeconomics, 4 th ed. Thomson South-Westen. Thomas, Lloyd, J. and li bdeezak "nticipated Futue udget Deficits and the Tem Stuctue of Inteest Rates." Southen Economic Jounal. July Tan, Dang T. and ansi L. Sawhney "Govenment Deficits, Capital Flows, and Inteest Rates." pplied Economics. June Yang, Z. ill and Mak. Yanochik On the Detemination of Inteest Rates in Geneal and Patial Equilibium nalysis. Jounal of Economics and Finance Education, Vol. 4 (No. 1). Summe

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