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ECO 2307
Chapter 10: CREDIT MARKETS
Learning objectives
- How a credit market matches borrowers and lenders (savers).
- How the credit market equilibrium determines the real
interest rate.
- The three key functions of banks.
- How banks can become insolvent, and the effects of bank
insolvency to the economy.
10.1 What is the Credit Market?
The credit market (also known as the loanable funds market) is
where borrowers obtain funds from savers. As always the case, a
market requires two sides to function, supply and demand. A
credit market consists of credit supply (savers/lenders) and
credit demand (borrowers), and institutions such as banks which
bring the two together.
Hence, credit markets are institutions that match the savers and
borrowers:they bring together savers and borrowers.
Credit markets perform the essential economic function of
channeling funds from savers to borrowers.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
2
(a) Borrowers and the Demand for Loans
Debtors: economic agents (borrowers) who borrow funds either to
invest or to consume.
Creditors: economic agents (lenders/savers) who lend the funds
to earn an interest.
Credit: the funds that debtors borrow (loans).
(b) Nominal and real interest rates
When businesses and individuals receive credit from banks, they
don’t use this credit for free. Debtors have to pay a price for
use of borrowed funds in the form of an interest rate (nominal
interest rate) per period of time, on the “principal”, that is,
on the original loan amount borrowed.
Nominal Interest ($) is the amount in dollar terms by which the
money paid back exceeds the principal loan (original money
borrowed). For example, let the principal be $1000, and the
payback $1100. The nominal interest is $100.
Nominal interest rate (i) is the percent by which the payback
exceeds the loan per period of time, without making any
adjustment for the change in the purchasing power of money
(inflation or deflation). The nominal interest rate is often
simply referred to as the interest rate. A “rate” is a percent.
In the above example the nominal interest rate is 10 percent,
that is,
$ଵ
$ଵ
∗ 100 = 10
Hence the payback in dollars is:
($) = + = (1 + ) = (1 + 0.10) ∗ 1000 = $1100
Businesses and households are optimizers, they seek to maximize
their profits. Thus, when interest rates are high, they borrow
less because fewer projects are likely to produce enough revenue
to cover the interest cost of borrowing, in addition to the
other project costs. When interest rates are low, they borrow
more (obtain more credit).
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
3
Real Interest ($): is computed by dividing the nominal interest
by the CPI. This adjusts the dollars of nominal interest to
remove the effect of inflation.
Real interest =
($)
∗ 100
The term “real” means that the nominal dollar value has been
adjusted for (controlled/protected from)inflation (price
changes). The inflation rate measures the speed at which the
general price level (Consumer Price Index) is changing in the
economy. It captures how much less valuable a dollar is becoming
because of the increase in the overall price level.
Real interest rate (r): This is the “true” cost of borrowing
money (obtaining credit). It is computed by subtracting the
inflation rate from the nominal interest rate as follows:
() = () – ()
This is also known as the Fisher equation: = ( – )
If you borrow a dollar at the beginning of the year, your
payback at the end of the year is ($1 + ∗ $1), that is,
(1 + ) ∗ $1
If there was an inflation rate (π), a dollar borrowed at
the beginning of the year has the same purchasing power as
($1 + ∗ $1) at the end of the year, that is, (1 + ) ∗ $1
Therefore, the real gain, which is the real interest rate
(r) from the loan is the difference between the payback
($1 + ) and the inflation adjusted value of the dollar
($1 + ), which is:
= ($1 + ) − ($1 + ∗ $1) = –
If banks don’t factor in inflation when calculating the
cost of lending (borrowing), it implies that a dollar
borrowed today has same purchasing power as a dollar year
from now. This can be true only if the inflation rate is
zero (0) percent.
Example: if the inflation rate is 3 percent, each dollar
borrowed and lent at the beginning of the year will have
same purchasing power as ($1 + ), that is, 1 + 0.03 = $1.03 at
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
4
the end of the year. If inflation is not factored in, and
the borrower simply pays back $1, the payback would have
the same purchasing power as $0.97 one year ago. Implying
a loss of $0.03 per dollar to the lender.
For the lender to have a real gain in purchasing power,
which is the real interest rate, the lender would have to
charge a nominal interest rate greater that the inflation
rate of 3 percent, for instance, 4.5 percent.
Real interest (rate) is, therefore, the transfer of
purchasing power from the borrower to the lender for the
benefit of borrowing.
c) The Credit Demand Curve
The credit demand curve represents the relationship between the
quantity of credit demanded and the real interest rate, other
things constant. Where the real “price” of credit is the “real
interest rate”. It is the cost of the loan (borrowing).
Other things constant, when the real interest rate increases,
the quantity of credit demanded decreases, and vice versa. This
change in “quantity of credit demanded” is illustrated by a
movement along the same credit demand curve.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
5
The steepness of the credit demand curve tells us about the
sensitivity or responsiveness (elasticity) of the relationship
between the real interest rate and the quantity of credit
demanded. It also represents how responsive borrowers are to
changes in the real interest rate.
If, for instance, the credit demand curve is almost flat, then a
small increase in the real interest rate results into a large
decrease in the quantity of credit demanded.
Shifts in the credit demand curve: at any possible level of the
real interest rate more or less credit is demanded.
Causes of shifts in the credit demand curve:
i. Changes in perceived business opportunities for firms.
Business borrow to fund their expansions, for instance,
when sales and/or when profitability increase over time.
If many businesses experience similar expansion trends and
increase their demand for credit at a given real interest
rate, then the aggregate demand curve for credit will shift
to the right, and vice versa. For example, since the late
1990s oil prices have had an upward trend. Accordingly, oil
companies invested in more exploration, drilling, and
transportation equipment, all of which required additional
demand for credit.
ii. Changes in household preferences or expectations.
Households borrow money to finance purchases of big-ticket
items: cars, furniture, TVs, etc. Any changes to their
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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preferences that lead them to consume more or less of such
items will shift the credit demand curve. Moreover, if
they have reason to expect that they will be in a better
financial position in the future, they may increase their
borrowing today knowing that they will be able to pay back
the loan in the future, and vice versa. An increase in
expected future income shifts the credit demand curve to
the right.
iii. Changes in government policy. When government spends more
than it collects in taxes, it runs a deficit. To cover the
deficit, the government borrows money from the credit
market, that is, the credit demand curve shifts to the
right. Also, in order to incentivize business to invest
more, the government may opt to lower taxes on corporate
profits. If firms respond positively to this government
policy, they will increase their desired borrowing at any
given interest rate, causing the credit demand curve to
shift to the right.
d) The Credit Supply Curve: the relationship between quantity of
credit supplied and the real interest rate, other things
constant. For dollar households consume today, they give up the
real interest they could have earned if they had saved and
invested the dollar. The higher the real interest rate, the
higher the opportunity cost of current consumption. When the
real interest rate rises, an optimizing household is encouraged
to consume less today and save more (increasing the quantity of
credit supplied) and invest.
An increase in savings leads to an increase in credit supply.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
7
Shifts in the credit supply curve: This is determined by changes
in the saving motives of the optimizing economic agents,
assuming the real interest rate is held constant.
i. Changes in the saving motives of households. Households
save money for many reasons, which change over time
shifting the credit supply curve. For example, if they
expect hard times ahead, they may increase the amount of
money they save, and vice versa. As households approach
the retirement age tend to save at a higher rate.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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ii. Changes in the saving motives of firms. Typically, firms
pay some of their profits as dividends to shareholders and
retain some of the earnings. The magnitude of retained
earnings changes over time. When firms want to expand or
are nervous about their ability to fund future business
activities they may retain more of the earnings. Thus,
would increase the supply of credit, shift the curve
outwards.
e) Equilibrium in the credit market
This brings together the credit demand curve and credit supply
curve. In the equilibrium, the quantity of credit demanded is
equal to the quantity of credit supplied at (Q*,r*).
At any real interest rate above r*, there is a surplus of
credit, which typically puts downward pressure on the real
interest rate.
On the other hand, if the real interest rate below r*,
there is a shortage of credit, and the credit market will
bid up the real interest rate.
