Video Transcript: Lesson 33

Okay, wrapping up Unit 11 here with Lesson Three, the credit market. We're  going to discuss the supply of loans in the credit market. This comes from one  private savings of households and firms, two savings or borrowing of  governments, and three savings or borrowing of foreigners. Okay, households  generally respond to an increase in the real interest rate by saving more. Higher  real interest rates also encourage foreigners to send funds to the domestic  economy. National savings are defined as private savings plus government  savings, or equivalent to private savings minus the government deficit. So  households will save more if nominal interest rates are higher and real interest  rates are higher because one, they'll have a greater return on their money if they leave it sitting in the bank, and they'll draw interest from those savings. And also, they may be considering buying CDs, certificate of deposits, which are going to  yield a higher interest rate that are that are very safe investments. So at times of higher interest rates, households will save more and consume less. And as  interest rates fall or go down, you know consumers will then begin spending. So  the total supply of savings is therefore equal to national savings plus the savings of foreigners. That is borrowing from other countries. The demand for credit  comes from firms who borrow to finance investment. As the real interest rate  increases, investment spending decreases. People want to borrow less money  as interest rates go up because they have to pay a higher price for borrowing  that money. For firms, a high interest rate represents a high cost of funding  investment and expenditures. Again, a higher interest rate is a higher cost of  borrowing. The matching of savings and investment in the aggregate economy  is described by the following equations: one, investment equals national savings plus borrowing from other countries, or investment equals national savings  minus lending to other countries. Okay, this is in an aggregate economy,  aggregate as a whole, the nation, region, state, locality as a whole, okay, in the  aggregate, not on an individual level. The response of savings and investment to the real interest rate is shown in the figure on the next slide. The credit market in equilibrium: the quantity of credit supplied equals the quantity of credit  demanded. Remember, in equilibrium, things are in balance; they equal supply  and demand are equal. We have assumed that the country is borrowing from  abroad, but nothing at all would change other than the way we describe the  supply curve. If the domestic economy were instead lending to other countries,  so here we'll see the supply curve. We'll see the equilibrium rate here, and we'll  see that it is upward sloping like it should be. Adjustment of the real interest rate  ensures that the flows into and from the financial sector are balanced. The  supply of loans comes from national savings plus borrowing from abroad, the  demand for loans comes from firms seeking funds for investment.