Overview
The lecture reviews the saving and investment model as it relates to fiscal and monetary policy in the 1920s, focusing on how public and private saving affect interest rates and business investment.
The Loanable Funds Model
- The loanable funds market uses supply (saving) and demand (investment) to determine the real interest rate.
- Demand for loanable funds (investment demand) comes mainly from firms wanting to borrow money for capital projects.
- Higher real interest rates reduce the quantity of loans demanded by firms.
- Supply of loanable funds (saving supply) comes from private (individuals) and public (government) saving.
- Higher real interest rates encourage more saving, increasing the funds available to lend.
- Equilibrium occurs where saving equals investment at the real interest rate.
Effects of Interest Rate Changes
- If the interest rate is too high, saving exceeds investment, causing a surplus of unused funds.
- Banks lower interest rates to reduce this surplus and attract borrowers.
- If the interest rate is too low, investment demand exceeds saving, causing a shortage of funds.
- Banks raise interest rates to encourage saving and limit borrowing, returning to equilibrium.
Fiscal Policy in the 1920s
- The US government ran budget surpluses in the 1920s, where tax revenue was greater than government spending.
- Budget surpluses increase public saving, shifting the saving supply curve right and increasing total (national) saving.
- Increased saving supply lowers real interest rates and encourages more business investment.
- Budget surpluses supported policies promoting US business growth in the 1920s.
Effects of Budget Deficits vs. Surpluses
- Budget deficits decrease public saving, shifting the saving supply curve left, leading to higher real interest rates and reduced investment ("crowding out").
- Budget surpluses have the opposite effect, boosting investment and stimulating business.
Key Terms & Definitions
- Real Interest Rate — the interest rate adjusted for inflation, guiding borrowing and saving decisions.
- Loanable Funds Market — the financial market where borrowers and lenders interact through saving and investment.
- Investment Demand — the desire of firms to borrow funds for capital projects at various interest rates.
- Saving Supply — the total funds provided by private and public saving for lending.
- Private Saving — savings from individuals and households.
- Public Saving — government saving, equal to tax revenue minus government spending.
- National Saving — total saving in an economy (private + public).
- Budget Surplus — when government tax revenue exceeds its spending.
- Budget Deficit — when government spending exceeds tax revenue.
- Crowding Out — reduction in investment due to higher interest rates from decreased saving supply.
Action Items / Next Steps
- Review appendix 9 for additional details on the saving and investment model.
- Prepare for discussion on fiscal policy changes in the late 1920s and early 1930s.