Tuesday, December 13, 2011

Why Monetary Policy Matters Anyway (part 1): Loanable Funds

As I've demonstrated earlier, I'm a euroskeptic (I didn't invent the term) primarily because of what I see as the disasterous experience of the ECB: the periphery countries of Europe have been saddled with a monetary policy that has been tailor-made for Germany and Germany alone; the result has been stable prices and full employment for Germany; unemployment and depressed incomes for Italy, Spain, Ireland, and others. Now I want to delve into why that is: why does the monetary policy of the ECB have an effect on the economic performance of European economies at all?

Monetary policy affects the economy by affecting interest rates: monetary easing lowers rates, while tightening raises them. Lower interest rates entice firms to borrow for investment projects and encourgae households to save less. Higher interest rates discourage borrowing for investment and encourage household saving. The market for loanable funds thus determines what the equilibrum rate of interest will be for the economy: the the graph below, savings is the upward-sloping function of the interest rate (r) and investment is the downward sloping function. This is known as the loanable-funds model.

The savings function is an upward-sloping function of the real interest rate because households want to save more when the reward for doing so it higher. The amount of saving, however, is determined by both the interest rate (r) AND the level of income (Y) so that we write S= f(r, Y). Investment is a downward sloping function of the real interest because more investment takes place when borrowing to do so is cheaper. Since S=I in equilbrium, holding (Y) constant, (r) adjusts until the quantity saved = quantity invested; the market for loanable funds clears like any other.

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