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15. Explain when minimum laws are binding and result in unemployment.

When the minimum wage is set above the equilibrium level, the result is unemployment. Minimum wages are binding most often for the least skilled and least experienced members of the labour force.


Financial intermediaries: indirect borrowing


take deposits from people who want to save and use the deposits to make loans to people who want to borrow.
pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans


Recall the GDP formula

Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:

Y = C + I + G + NX


Recall the GDP formula as a closed economy

Assume a closed economy – one that does not engage in international trade (imports and exports are zero):

Y = C + I + G

I = Y - C - G


Y - C - G

the total income in the economy after paying for consumption and government purchases.

This is referred to as National saving, or just saving (S).

Substituting S for Y - C - G, the equation can be written as:
S = I


National saving, or saving, is equal to:

S = I
S = Y – C – G
S = (Y – T – C) + (T – G)


National Saving Consists of

Private and Public Components


Private saving

Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.
Private saving = (Y – T – C)


Public saving

Public saving is the amount of tax revenue that the government has left after paying for its spending.
Public saving = (T – G)


Budget Surplus and Deficit

If T > G, the government runs a budget surplus because it receives more money than it spends.
The surplus of T − G represents public saving.
If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue


The market for loanable funds

Financial markets ‘coordinate’ the economy’s saving and investment in the market for loanable funds.
The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds


Loanable funds

Loanable funds refer to all income that people have chosen to save and lend out, rather than use for their own consumption


the supply of loanable funds

The supply of loanable funds comes from people who have extra income they want to save and lend out.


The demand for loanable funds

The demand for loanable funds comes from households and firms that wish to borrow to make investments.


Interest rate

The interest rate is the price of the loan.
It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.



Interest represents a payment in the future for a transfer of money in the past.


Nominal interest rate (i)

The nominal interest rate (i) is the interest rate usually reported and not corrected for inflation.
It is the interest rate that a bank pays or asks for


Real interest rate (r)

The real interest rate (r) is the nominal interest rate that is corrected for the effects of inflation: r = i – inflation


Supply and demand for loanable funds

Financial markets work much like other markets in the economy.
The equilibrium of the supply and demand for loanable funds determines the real interest rate.


The market for loanable funds graph

Photo in favourites 17/8/18


What government policies can affect saving and investment?

taxes on saving
taxes on investment
government budgets


Pros and cons of government budget deficits

Stimulates the economy when in recession

Accumulation of government debt
Crowding out effect


The effect of a government budget deficit

1. A budget deficit decreases the supply of loanable funds for any interest rate

Shifts the supply curve to the left.

2. Which raises the equilibrium interest rate

3. And reduces the equilibrium quantity of loanable funds in dollars

Photo in favourites 17/8/18


Crowding out effect (occurs during government budget deficits)

Crowding out refers to the tendency for increased government deficits to reduce investment spending. Specifically, the reduction in investment stems from the fact that a decrease in public saving reduces national saving, pushing up the real interest rate in the loanable fund market.


What does a decrease in the tax rate on savings do to households’ incentive to save (at any given interest rate)?

The supply of loanable funds curve shifts to the right.

The equilibrium interest rate decreases.

The quantity demanded for loanable funds increases.

Photo in favourites 17/8/18


What does an increase in the investment tax credit (i.e. a decrease in the effective corporate tax rate) do to firms’ incentive to borrow (at any given interest rate)?

Increases the demand for loanable funds.

Shifts the demand curve to the right.

Results in a higher interest rate and a greater quantity saved.

Photo in favourites 17/8/18


4. The demand for loanable funds is downward-sloping because:

a.as the interest rate falls, the demand for loanable funds increases

b.as the interest rate falls, the demand for loanable funds falls

c.as the interest rate rises, the quantity of loanable funds demanded rises

d.as the interest rate rises, the quantity of loanable funds demanded falls

ANS: D The demand for loanable funds comes from businesses’ willingness and ability to invest in business productive capital and ventures. As the cost of investing (the real interest rate) increases, the potential profitability of investments decreases. Thus, as the real interest rate rises, businesses are less willing and less able to proceed with investment plans, consequently the overall quantity demanded of loanable funds (for business investment) declines.


Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if the investment tax credit is abolished.

As shown in the graph below, the economy starts in equilibrium at point E0, with interest rate r0 and equilibrium quantity saved and invested at q0. If the investment tax credit is abolished, the incentive to invest is reduced, and less investment will be undertaken at each interest rate. Therefore, the demand-for-loanable-funds curve shifts from D0 to D1. The new equilibrium is at E1, with a lower interest rate, r1, and a lower level of saving and investment, q1. Hence, elimination of the investment tax credit reduces interest rates and reduces investment.

Photo in favourites 27/8/18



The set of assets in an economy that people regularly use to buy goods and services from other people. Money includes cash, deposits and other types of assets, but not credit card (or cheques). In fact, if people use cheques instead of cash, money supply will increase as people no longer carry extra cash.


The 3 functions of money

Medium of exchange

Unit of account

Store of value