Thursday, January 3, 2013

The loanable funds market

I've been thinking about the Austrian model, as described in Garrison's book, and its relationship with monetary economics.  Here is the Austrian model in a nutshell:

The economy is somewhere along the production possibilities frontier in the upper right: $$Y = C+I$$.  The level of investment is by definition equal to the level of saving in the economy - that is, it is determined by the loanable funds market, where the saving (= supply) and investment (= demand) curves interact.  When the loanable funds market is in equilibrium, $$S = I$$ at some equilibrium interest rate $$i_{eq}$$.  Consumption, meanwhile, is equal to the value of all final goods and services, which have been produced over some period of time.

The interest rate pressures the intertemporal structure of production toward a particular slope.  That is, the rate at which value is added to goods as they move through stages of production (remember Macro 101, when you discuss why $$Y$$ is the sum of final goods and services?) is pushed toward the interest rate.  If the value-added of a good compared to its production time is higher than the interest rate, firms will take advantage of arbitrage and invest in producing more of the good, increasing demand for loanable funds and decreasing the price of the good.  If the value-added of a good compared to its production time is less than the interest rate, investors will discontinue investment in firms producing the good and push the relevant funds into other investments, decreasing the interest rate and increasing the price of the good as marginal firms go out of business.

(There is an interesting discussion to be had at some other time as to the impact of interest rates on the internal structure of firms which encompass multiple steps of the production process.  The interest rate should "flex" such firms.)

While the chief contribution of the Austrian model is in disaggregating the capital structure of the economy and thus providing a mechanism by which the long-run can arise over many periods, here I want to think about the loanable funds market and the insight its particular abstraction gives into the broader structure of the economy.

Returning to the circular flow of Macro 101, firms purchase labor from households and households purchase final goods and services from firms.  Of course, this is a lie - in fact, the economy is a giant tangled mess of firms purchasing goods and services from each other, households selling their labor all over the place, firms purchasing labor from other firms, households selling goods and services to firms and other households, and we haven't even thrown the financial industry or the government into the mix - firms and households saving money through the financial industry, which fishes for investment opportunities, and of course the government with its sticky fingers and regulators in most transactions in the economy.

What's the function of the financial industry?  Steve Waldman opines that the financial industry is a morass of opaque risk-taking. Households don't want to know what sort of risks they're taking - they just want some return on their money.  Investments are repackaged, sliced, diced -- risk is packaged and maneuvered and spread out.

Let's run with the image of finance as a morass - literally.  Think of finance as a swamp through which water drains, from a lake on one side to a lake on the other.  At the end of the marsh, there's a steady current into the ocean, and on the one end, there's a steady current into the marsh.  But in the marsh, the water slowly wends this way and that, following aimless little streams and stopping in stagnant ponds, before it eventually outs into the lower lake.

But as far as the macroeconomy is concerned, the financial system is a black box.  Water goes into the swamp from one side and comes out the other.  Investors put money into one side, firms bid for investments on the other side, and the financial system equilibrates the two.  But., much like hot dogs and Project Mayhem, the first rule of finance is you do not ask questions about how it works.

Perhaps more to the point, you don't need to know how it works to know that it functions as a clearinghouse between investors and firms.  That's the beauty of the loanable funds model: it abstracts away the financial system so that details of financial interactions don't distract from the larger picture of the macroeconomy. As far as the macroeconomy is concerned, the details of how money moves from savers to investing firms is not relevant.  What matters is the capital stock accumulated via investment, the level of consumption deferred, and the impact of these decisions on growth and employment.

In order to place the financial system inc ontext, observe that the loanable funds market presents a savings (supply) curve and an investment (demand) curve relating dollars to a (single, risk-adjusted) interest rate.  We can interpret the savings curve as the relationship between the interest rate offered by the financial system and the willingness of savers to inject funds into the financial system.  Likewise, the investment curve is the relationship between the interest rate offered by the financial system and the willingness of firms to borrow funds from the financial system.

These curves and their interaction contain the macroeconomically relevant information in the financial system. Any macroeconomically relevant event in the financial system will manifest itself as a movement of curves in the loanable funds model.  Any macroeconomically irrelevant event in the financial system will be completely invisible in the loanable funds model - as it should be!