Loanable Funds Market: Supply, Demand, and Interest

• The loanable funds market includes stock exchanges, investment banks, mutual fund firms, and commercial banks.
• Borrowers get funds to use for businesses.
• Savers lend to these businesses.

Supply and Demand

• The supply of loanable funds comes from people saving money.
• The interest rate is a reward for saving.
• The demand for loanable funds comes from people wanting to borrow money.
• The interest rate is the cost of borrowing.

Interest Rates

• The interest rate is the price of loanable funds.
• Savers receive the interest rate as the reward for saving.
• Borrowers pay the interest rate as the cost of borrowing.
• The interest rate rises and falls like other prices.
• The interest rate is affected by supply and demand
• The loanable funds market can be examined like any other market.
• The price is the interest rate
• The sellers/suppliers are savers
• The buyers/demanders are borrowers

Loanable Funds Market

• Savers, including households and foreign entities, supply savings to the loanable funds market.
• Borrowers, including firms and governments, demand loans from the market.
• Every dollar borrowed requires a dollar saved, as lenders can't lend money they don't have; they get that money through savings.

Demand for Loanable Funds

• Demanders of loanable funds are entities who want to borrow money.
• Demand is largely driven by firms who need to borrow for large capital projects.
• Governments also borrow.

Factors that Shift the Demand of Loanable Funds

• Economic growth leads to businesses borrowing for investment and increasing demand.
• Increased government borrowing (fiscal deficits) can raise the overall demand for loanable funds, known as the crowding-out effect.
• Monetary policy dictates that higher interest rates generally decrease the demand for loans, as borrowing becomes more expensive; conversely, lower interest rates increase demand.
• Changes in the productivity of capital lead to business generating higher returns on their investments.
• e.g. The Internet makes computers more productive
• Changes in investor confidence also affect demand.
• John Maynard Keynes referred to this effect as "animal spirits."

Factors that Shift the Supply of Loanable Funds

• Household income and wealth affects the supply of loanable funds.
• Central bank policies influence the supply of loanable funds through monetary policy.
• Increasing the money supply increases funds available for lending.
• Foreign capital inflows: An increase in foreign investment or lending (capital inflows) can increase the supply of loanable funds in a country.
• The Impact of inflation on interest rates: Higher expected inflation can reduce the real value of savings, potentially decreasing the supply of loanable funds (Fisher equation).
• Change in time preferences: Lower time preferences indicate that people are more patient and more likely to save for the future.
• Consumption smoothing (Income changes over the course of the typical lifetime).

Equilibrium in the Market for Loanable Funds

• In equilibrium, savings equal investment.
• The relationship between saving and borrowing is that every dollar borrowed requires a dollar saved.

Explore the loanable funds market, where borrowers and savers interact. Understand how the supply and demand for funds determine interest rates. Learn about the roles of savers and borrowers in this market.