Present Value
PV = R₁/(1+i) + R₂/(1+i)² + R₃/(1+i)³ + … + R_n/(1+i)ⁿ

if I goes up, (1+i) goes up, …
and each element in the sum goes …
down, so the PV goes down

Loanable Funds Model: Supply
Personal savings
Business savings
Government budget surplus
Increases in the Money Supply
Foreign lending in the U.S.

Loanable Funds Model: Demand
Household credit purchases
Business investment
Government budget deficit
Foreign borrowing in the U.S.

Loanable Funds Model
Decreasing Household Thrift

Banks Tighten Lending Criteria

Fed Decreases Money Supply

Consumer Confidence Improves

Budget Deficit Goes Down

Stock Market Crash

Inflationary Expectations
Savers/lenders who expect inflation must avoid lending some of their savings ….
they expect they’ll need more of their savings to pay expected higher prices.
Borrowers who expect inflation want to borrow more ….
to pay the higher prices they expect.

The Fisher Equation
i = r + (beta)p^e
i = nominal interest rate
r = real interest rate
beta = adjustment coefficient
p^e = expected inflation rate

The Fisher Hypothesis
beta = 1….

i = r + p^e

Interest Rates and the Money Supply
Liquidity effect
Income effect
Inflation expectations effect

The Liquidity Effect
Increase in M….
increases supply of loanable funds…
lowering i….

The Income Effect
after M increases…
the economy responds to the additional liquidity by expanding output and expenditures, also raising factor income…
lowering i further….

The Inflation Expectations Effect
If increasing M leads people to expect higher inflation than before…
the Fisher Effect raises interest rates.

Fisher effect: Savers want to save more, lowering S, and borrowers want to borrow more, increasing D.
Interest Rates and the Business Cycle
i tends to rise in booms, as demand for loanable funds is high, and often supply (savings) is low.

Short-term interest rates are procyclical
Less pronounced for longer-term rates – why?

Ricardian Equivalence
Every $ the government borrows, is a $ held by the public in a treasury bond.
Increases in the demand for loanable funds are balanced dollar-for-dollar by increases in saving – supply of loanable funds
i does not increase.

Ricardian Equivalence
Budget Deficit: Government Sells Bonds to Borrow Money
Savers buy Bonds

Ricardian Equivalence
Only applies if people save more now, dollar-for-dollar….
in anticipation of future tax increases….

required to pay off bonds.