1. The Loanable Funds theory
We use the term “loanable
funds market” to describe the
arrangements and institutions
by which saving of households
is made available to borrowers.

2. Factor income
Consum
ption
1. Leakages must be recycled
if total spending is to
match full-employment
GDP.
2. According to the Classical
theory, the loanable funds
market acts as a conduit to
transfer spending power
(S) from households to
borrowing units (firms and
government units).
3. Saving (S) is the “source”
of loanable funds.
Saving
Nettaxes

3. 1. To have a more secure future, to start a
business, to finance a child’s education,
to satisfy miserliness, . . .
2. To earn interest.
We view interest as
the “reward for
saving” or the
“reward for
postponing
gratification.”

4. Interest rate Future value
4% $1,127.27
5% $1,161.47
6% $1,196.68
7% $1,232.93
8% $1,270.24
9% $1,308.65
10% $1,348.18
11% $1,388.88
12% $1,430.77
Value of $1,000 in 3 years at
alternative interest rates
The opportunity cost
of spending now
(measured in lost
future spending) is
positively related to
the interest rate.

5. Saving = Supply
of Funds
Trillions of
Dollars
0
Interestrate
3%
5%
1.5 1.75
Supply of Funds

6. •To finance the acquisition of long-lived capital goods.
•The rate of interest is the cost of borrowing or the price of
loanable funds.
•The investment demand curve indicates the level of
investment spending at various interest rates.
•As the interest rate decreases, more investment projects
become attractive in the assessment of business decision-
makers—hence, the investment demand function is
downward-sloping with respect to the interest rate.

7. Investment
Demand
Trillions of
Dollars
0
Interestrate
3%
5%
1.5
Demand for Funds
by Business
1.0
A
B
When the interest rate falls,
investment spending and the
business borrowing needed to
finance it rises.

8. Public sector borrowing
•Let G denote public sector (or government)
spending for goods and services in a year
•T is net tax receipts in a year.
•If G is greater than T, the the public sector
has a budget deficit equal to G – T.
•If T is greater than G, then the public sector
has a surplus equal to T – G.
•If the public sector has a budget deficit, it
must borrow.

10. Public Sector Borrowing in Classica
G = $2 trillion
T = $1.25 trillion
Therefore,
Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion
0.750
5%
3%
Government
Demand for Funds
InterestRate
Trillions of Dollars
A
B

11. [1] [2] [3]= [1]+ [2]
InterestRate Business Demand GovernmentDemand Total Demand
5% 1.0 0.75 1.75
3% 1.5 0.75 2.25
Demand for Loanable Funds (in Trillions)

12. InterestRate
Trillions of Dollars0
3%
5%
1.75 2.25
Total Demand for
Funds

13. InterestRate
Trillions of Dollars
Loanable Funds Market Equilibrium
Total Supply of
Funds (Saving)
Total Demand
for Funds
(Investment +
Deficit)
E5%
0
1.75

14. Why does the loanable funds theory
guarantee the validity of Say’s law?
S = IP
+ G - T
Quantity of Funds
Supplied
Quantity of Funds
Demanded
Now, rearrange the equation above by bringing T
to the left side:
S + T = IP
+ G
Leakages
Injections

15. So long as the loanable funds
market “clears,” leakages
(Saving) will be offset to
injections (investment and
government spending).

16. Firms
Government
Households
Resource
Markets
Goods
Markets
Loanable Funds
Markets
Income ($7 Trillion)
Factor Payments
($7 Trillion)
Government
Spending ($2
Trillion)
Investment
($1 Trillion)
Consumption
($4 Trillion)
Firm Revenues
($7 Trillion)
Deficit
($0.75
Trillion
Income ($7 Trillion)
Saving ($1.75 Trillion)
Net Taxes
($1.25 Trillion)

17. Changes in government spending, transfer
payments, and taxes designed to change total
spending in the economy and thereby influence total
output and employment.

18. The Classical view of Fiscal policy
Friends, we believe that fiscal
policy is unnecessary and
ineffective. The economy is doing
just fine without meddling by
Washington.

19. •Crowding out is the idea that an increase in one
component of spending will cause a decrease in other
spending components.
•An increase in G may cause a decrease in C, IP
, or
both—that is, government spending may “crowd out”
private spending.

20. InterestRate
Trillions of Dollars
Crowding Out With an Initial Budget Deficit
Total Supply of
Funds (Saving)
D1 = IP
+
G1 - T
H
5%
0 1.75
D2 = IP
+
G2 - T
7%
2.05 2.25
A C
B •Increase in G = AH
•Decrease in C = AC
•Decrease in IP
= CH

21. InterestRate
Trillions of Dollars
Effects of a Reduction in the Government Surplus
S1 = Savings + T – G1
D = Investment
B
5%
0 1.75
S2 = Savings + T – G2
A
H
7%
C
1.25 1.55