Supply and Demand for Loanable Funds and for Foreign-Currency Exchange - Essay Example

A macroeconomic Theory of the Open Economy, Supply and demand for Loanable Funds and for Foreign-Currency Exchange In economics theory, a market for loanable funds is a place where the savers and demanders together also where money in the financial institutions like commercial banks and the lending institutions are brought together for consumers who include the households and firms to use the to meet their expenditures as consumption and investment. Money from all the institutions meet and enable the conduction of economic activities (McConnell, Campbell, Brue and Stanley 96- 122). Those entities that save as the consumers, provide the loanable funds to the demanders by either buying bonds an activity that transfers their money to bond issuers, for example, the firms or the government. To balance the condition and allow the exchange, there is demand for the funds by the borrowers when they sell the bond that they have to the savers. An exchange in any market can only occur if there are demanders and suppliers. The funds consist of the loans from the banks and savings saved by the consumers foregoing consumption. Therefore to save involves a sacrifice and the savers in exchange demand for compensation for the best alternative foregone had they consumed the funds instead of saving them. The concept of compensation and incurring a cost is, therefore, is very important for the sustainability of the funds market (McConnell, Campbell, Brue and Stanley 92). The loanable funds are usually used for investment in new capital goods bringing about the concept of the supply and demand for the funds. The lenders bring about the supply curve that is upward sloping from left to right while the borrowers bring about the demand curve that is downward sloping from the left to the right. The curves are guided by the principle of demand and supply which states that, supply increases with the increase in the price while demand increases with a decrease in price. The conflicting ideologies calls for an equilibrium where the two intersect and those to make a decision agree. The interest rate is the sacrifice or cost of borrowing the loanable funds from the suppliers and it is the value of money that a person pays for using the dollar for one year. It is also the benefit or compensation to the person or entity supplying the funds. The rate of interest is usually expressed as a percentage of annual funds spend or borrowed. When dealing with the loanable funds one considers the interest rate which is adjusted for inflation to take care of the price changes. It is essential to ponder on the rate of interest that is real than a nominal one that has not been adjusted in order to reflect the true gains or losses by the participants in the market. Point of equilibrium determined by the contact of demand and supply curves. Firms or individuals who borrow the loanable funds consider the rate of return on the capital they are willing to borrow. The return is an additional income or revenue the investor expects to earn from the investment in additional capital. If the rate of return resulting from such an investment is higher or it is equal to the cost being charged (interest rate) on the borrowed resources, investors should continue to borrow the loanable funds. The anticipated returns should be a key consideration when any entity wants to make any investment (McConnell, Campbell, Brue and Stanley, 86). An open economy is one where there is a flow of economic activities between the local people and those of another country. Buying or carrying in properties and services from a different country is called importing while selling goods and other facilities to an overseas state is called exporting. The two activities bring about international trade. Exporting leads to an inflow of funds or capital while importing leads to an outflow of funds to a foreign country. International trade has expanded the loanable funds available to the demanders as well expanded the market to which the suppliers can supply the funds they have. The difference between the amount being lent abroad from the local economy and that being lent to the local economy from abroad results into a net capital outflow. It is important for a country to participate in an open economy in order to benefit from a wide pool of demand and supply of assets. An open economy expands and grows faster than a closed economy. The following identity is used to elaborate on the concept of loanable funds market. S = I + NCO Savings = domestic + net capital Investment outflow If the dollar is saved it is used to purchase capital in the local economy or to finance assets from abroad. Therefore, the two sides of the loanable funds come from the national savings that comprise the supply curve while the net capital outflow and domestic investments comprise the demand side. The loanable funds in this case, comprise resources generated domestically for accumulation of capital. When an asset is purchased it adds to the demand of loanable funds regardless of the location of the asset be it locally or abroad. If it is located in the domestic market its purchase results to domestic investment while if in the foreign location results to the net capital outflow. The net capital outflow can either be positive or negative. If positive, then the country has more inflows of capital increasing the demand for local loanable funds while if negative the country has more outflows of capital decreasing demand for local loanable funds (McConnell, Campbell, Brue and Stanley, 112). Because the funds supplied and the funds demanded depends on the real interest rate, where, a higher real rate of interest motivates people to save because they predict higher return that increases the loanable funds available of supplied. Investors are willing to invest more when the interest rates are low while, on the other hand, savers want to save more at a high level of interest which indicates their income or returns from such savings. At higher levels of interest the cost of acquiring the loanable funds by the investors is unbearable and, therefore, high interest rates discourage the demand for loanable funds. When the demand for loanable funds is discouraged, the savers will be forced to lower the rate which the charge on their assets. On the other hand, a higher real rate of interest makes borrowing expensive because it increases the cost to be incurred to finance projects that discourage investments reducing the demand for loanable funds. Therefore, the level of real interest rate affects a country’s net capital outflow. If it is the government that is borrowing funds from the economy by issuing bonds, it calls for the savers to purchase these bonds and give the government the money or the loanable funds. To entice the savers to buy the bonds, the government has to charge interest rate on the returns that arise after the purchase of the bonds by the savers (86-90). A country with a lower real interest makes its assets unattractive and encourages the local people to buy assets from elsewhere causing capital outflow increasing the net capital outflow which places the country at a disadvantage. The local economy does not grow because there is no local or foreign investments occurring or coming into the country. For there to be an equilibrium in the economy where the savers and the demanders of loanable funds agree the government has to set a real interest rate that is arrived at after the joint of the demand and the supply of loanable funds curves. This graph was adapted from McConnell, Campbell R.; Brue, Stanley L, Economics. McGraw-Hill Professional. (2005), 83-114. As in the above diagram, the interest rate charged and the amount of loanable funds supplied determines the equilibrium point where there is no crisis in the market. Due to the flexibility of the interest rate, the rate adjusts back to equilibrium in case it is away from the point of equilibrium. For example if the rate is higher than the equilibrium level the amount of loanable funds demanded would be lower than the amount supplied resulting to crisis ( 98-106). The excess supply pushes the rate down up to the point of equilibrium. Conversely if the rate is lower than the equilibrium level the funds demanded rises higher than what the suppliers supply, the low supply pushes the rate high back to the level of equilibrium. Therefore, at the point of stability the demand equal the supply and at this interest rate people saves exactly what matches the demands for local investment and net capital outflows. Any government that wants to experience a stable economy should consider establishing the equilibrium level through a market research. Otherwise, any other level of interest other that the steady state equilibrium will bring about imbalances in trade. Loanable funds and crowding out. Crowding out happens when the regime rises its purchases that in turn causes an increase in the demand for loanable funds. There is a shift in the demand curve to the right side causing a rise in the interest rate and a rise in the amount of loanable funds. This graph was adapted from McConnell, Campbell R.; Brue, Stanley L, Economics. McGraw-Hill Professional. (2005), 83-114. The difference between the new Q” and the old Q’ indicates that much of the investment that is private is crowded out because firms have few capital left to invest when the state borrows from the savers. The situation is not healthy for the economy because it might lead to shortages in supply of the customized goods to the demanders and other crises that arise due to publically provided goods as externalities. There is a requirement to strike a stability between the private investments and the government investments for an efficient economy. In conclusion, the trading in loanable funds is very necessary for the globe as it is bringing in cohesion and opening up the exploitations of the resources. There is mobility of labor between nations that are helping to a great extent it is trying to solve the problem of unemployment. Availability of loanable funds in the economy help in boosting the economic growth and development as they are the resources that are invested by the investors to bring about increase in production. They are invested in things like the infrastructure, industrial development, service industries and agricultural sectors. This boosts the available goods and services that meet the demand for consumers (111-114). Foreign Currency Exchange Market. The demand for international trade between nations where people can exchange goods and services freely across borders is a key factor that has led to the development of foreign exchange market. It is a market where the exchange of currency of different countries takes place. The value of different currencies is compared to the dollar because it is the accepted standard for international trade (McConnell, Campbell, Brue and Stanley, 111). The market is comprised of representative institutions like larger banks and insurance companies who trade in the currency on behalf of a wide range of demanders who wish to export or import their products. The market has minimal supervisory that regulates the types of actions carried on. The currency market helps the conduction of international trade through enabling the conversion of currency. For example, United States can trade with states in the Europe and pay in terms of euros even though the currency of the USA is in dollars. The currency marketplace is the most liquid marketplace that deals with finances in the world. The traders include corporations, central banks, institutional investors, financial institutions, large banks, currency speculators, and retail investors. The turnover of the currency market expands on a daily basis. The central banks of nations play a major role in the currency exchange markets because they are in charge of the currency status of the country. The control inflation, the supply of money and the levels of interest rates and play official and unofficial roles to meet the targets of the country’s currency. Therefore, foreign currency trading forms an important wing of the government because it can be used to regulate the costs of properties and facilities in the county (McConnell, Campbell, Brue and Stanley, 111). Some government operates a fixed regime of exchange in which case the value of the country’s currency is fixed. The value does not respond to the forces of demand and supply in the international trade market. Such behavior calls for the intervention of the monetary authority to fix the value at which the country’s currency will be exchanged for in exchange for other currencies. The regime achieves the desires of the county in the short term, but it can lead to the crisis in the long run given the volatility in the market of currencies. Other countries operate on a flexible regime on which the value of the currency changes in response to changes in the currency market. It is a very dangerous regime because it can cause losses to the country if the country trades with nations that have very stable currencies and the country is a heavy importer. On the other hand, some nations apply the dirty float regime in which case it controls the value of the currency and at the same time the currency is flexible to the changes in the market. It is a very practical regime because interventions by the government comes in at the necessary time to achieve the set goals. There are theories that explain the factors that determine the value of a currency in the currency. They include, parity conditions in the international market like how the purchasing power differs between nations, differences in the rate of interest, domestic and international Fisher effect. The theory explains why there are fluctuations, but it fails in the case that it is based on assumptions that are weak (McConnell, Campbell, Brue and Stanley, 112). Another theory is a balance of payment model that is mainly based on tradable goods and services which fail to explain the causes of the fluctuations on the dollar that have been experienced in the past. The aspects that upset the worth of the currency include, economic factors which include things like the policy adopted comprising the monetary and the fiscal policy that determines the interest rate charged which determine the value of the currency, status of the government budget in which case a widening budget deficit causes loss of trust in the currency affecting its value, inflation level experienced such that at higher levels of inflation the currency is lowly valued in the market, the trade balance between nations in which case a high flow of goods between nations pushes the demand for the currency of that country increasing its value and economic growth experienced with the currency of the country with a high growth in the economy being highly valued (McConnell, Campbell, Brue and Stanley, 112). Political issues also play a part in defining the value of the currency with the country that is politically stable, its currency is highly valued. Political wrangles to a great extend affect the performance of the country in the international trade that causes the reduction in the value of its currency because no investors are willing to invest in such a country. The following identity explains the concept of demand and supply of foreign currency. NCO = NX Net capital outflow = Net exports The demand for foreign currency depends on what the currency is able to buy in its original country so that the demand increases if there are many goods and services from that country to other countries. The supply of foreign currency depends on many composite issues and flows to a country if there are a lot of exports from than imports between two countries. The figure below indicates how the demand for dollars is determined. Where an increase in the price for dollars, increase its demand. This graph was adapted from McConnell, Campbell R.; Brue, Stanley L, Economics. McGraw-Hill Professional. (2005), 83-113. The supply is said to be price elastic if the sellers respond quickly to the changes in the cost of the currency while, if they are not responsive like to the currency of an unstable country, the supply is said to be price inelastic (McConnell, Campbell, Brue and Stanley, 113). The above identity shows that the imbalances between purchase and sale of capital abroad equals the imbalances between exports and imports. There is a steady state condition between the flows of capital between nations. For example when the United States is experiencing e trade surplus, the foreigners are buying most of their goods and services than what the locals are importing from abroad. Therefore, the local people are using a foreign currency to buy assets from abroad resulting to an outward flow of domestic currency and increasing the demand for foreign assets striking a balance between the trading nations Conversely, if the United States is experiencing a trade deficit then the local people are buying more of the foreign assets causing an outward flow of capital for spending more on the foreign capital than they are earning. There is a need to finance this by selling the foreign assets abroad resulting to an inward flow of capital from abroad. There is always an equilibrium in the flow of capital between the two trading nations in the foreign currency market. This is because when one country is on a deficit balance of trade the other partner is on a surplus and both of the nations are enjoying the exchange of services and in the end the forces of demand in the market bring stability back. It is divergent to the conviction of many managers who take a deficit as bad performance of the county. The position of the country in the balance of trade depends on many things including the level of development experienced in the country and the endowments in the natural resources. Stable countries economically like the United States will always perform better than the unstable countries like Pakistan if they trade in the currency market. Therefore, it is essential for a nation to participate in this market because the benefits overwhelm the disadvantage therein. For a nation to benefit from the market of foreign currency it is necessary determine the point of equilibrium in the value of its currency relative to the dollar. In conclusion, the participation of the country in a foreign currency market affects its economic performance. Competition brings about specialization and production of quality produce to see the demands of the global markets to enable exports that bring in the dollars to the country. It enables it to compete globally and discover the main area of interest to enjoy the many economic benefits that the market offers. Therefore, it is a very pivotal market that all countries should participate. Work cited McConnell, Campbell R.; Brue, Stanley L, Economics. McGraw-Hill Professional. (2005), 83-114. Read More