2.3The composition of aggregate demand

In Chapter 1 we saw that some people have incomes which exceed that which

they require for current composition. This excess is saving. That saving may simply

be ‘hoarded’ (i.e. not spent on anything), or it may be used to nance the saver’s

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Chapter 2 • The nancial system and the real economy

Figure 2.1(a)

Figure 2.1(b)

capital spending, or it may be lent to others to nance their capital spending. We

also said that borrowers and lenders had different motives and therefore different

needs. Broadly, lenders like to maximise liquidity and yield while borrowers like

to maximise the length of their borrowing while paying the minimum cost. If we

adopt the customary device in economics of assuming other things are equal, we can

show how, in Figure 2.1(a), the willingness of lenders to lend and of borrowers to

borrow will vary with the rate of interest on borrowing and lending. Other things

being equal, the demand for ‘loanable funds’ by borrowers will be inversely related

to interest rate (the price they have to pay), while the supply will be positively

related.

Notice that the stability of these curves is not without controversy, however. In

Figure 2.1(a) an increase in income will cause the supply curve to shift to the right.

In addition, some would argue that the demand curve is unstable, shifting outwards

as borrowers sense a more ‘protable’ future for the projects they hope to nance,

and in towards the origin as their outlook becomes more pessimistic.

In addition to the level of income and the state of ‘expectations’, the positions of

the curves will be inuenced by the quantity and nature of nancial intermediation.

In Figure 2.1(a) the supply of lending is equal to the demand for lending at an interest

rate r. At r, given their level of income at the current level of risk and inconvenience

11

involved in allowing others the use of their funds, savers are prepared to lend just

the amount that borrowers wish to borrow. Suppose now though that some form

of nancial innovation occurs which savers nd particularly attractive. If the rate

of interest remains at r, more lending will be forthcoming. The same would be true

1

for any level of yield which we care to choose, and the curve showing the supply

of lending needs to be redrawn at S′. At r, the supply of lending now exceeds the

1

demand for it and we should expect the rate of interest to fall, and demand for

funds to increase, until both become equal again at r. Other things being equal, we

2

may say that an increase in the volume of intermediation will increase the supply of

funds and lower the cost and increase the volume of borrowing.

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