What if you’re making enough money and want to start saving some? Where do you find someone willing to pay you for using your money? All these questions are addressed using the loanable funds market.
The loanable funds market helps you understand how savers and borrowers are brought together in an economy. The loanable funds market is essential in helping you understand and analyse macroeconomic development.
Loanable funds market definition
In any given economy, saving is the primary source of investment. When an economy is closed, investment is equal to the national savings, and when there is an open economy, investment is equal to the nationwide savings and capital inflow from other countries. That is to say, the money saved from households and Governments is channelled to investors who then borrow this money to invest them.
How do these savers and borrowers come together? Where do investors find savers willing to lend their money?
The loanable funds market is the market that brings savers and borrowers together.
Savers in this market are on the supply side as they are willing to supply their money to borrowers. On the other hand, borrowers provide the demand for savers’ money.
National savings is the total of public and private savings when there is no international borrowing and lending.
Interest rate and loanable funds market
The interest rate in the economy dictates the price at which savers and borrowers agree to either lend or borrow.
The interest rate is the return savers receive back for allowing borrowers to use their money for a defined period. Additionally, the interest rate is the price borrowers pay for borrowing money.
Interest rate is an instrumental part of the loanable funds market as it provides the incentive for savers to lend their money. On the other hand, the interest rate is also critical for borrowers, as when the interest rate increases, borrowing becomes relatively more costly, and fewer borrowers are willing to borrow money.
The main point to keep in mind is that the loanable funds market is the market that brings together borrowers and savers. In this market, the interest rate serves as the price through which the equilibrium point is determined.
The demand for loanable funds
The demand for loanable funds consists of borrowers looking to finance new projects they want to engage in. A borrower could be looking to buy a new house or an individual who wants to open a start-up.
Figure 1. Demand for Loanable funds, StudySmarter Originals
Figure 1. depicts the demand curve for loanable funds. As you can see, it is a downward-sloping demand curve. You have the interest rate on the vertical axis, which is the price that borrowers have to pay for borrowing money. As the interest rate goes down, the price borrowers pay also goes down; therefore, they will borrow more money. From the above graph, you can see that an individual is willing to borrow $100K at an interest rate of 10%, whereas when the interest rate comes down to 3%, the same individual is willing to borrow $350K. This is the reason why you have a downward sloping demand curve for loanable funds.
The supply of loanable funds
The Supply of loanable funds consists of lenders willing to lend their money to borrowers in exchange for a price paid on their money. Lenders usually decide to lend their money when they find it beneficial to forego some of today's funds' consumption to have more available in the future.
The main incentive for lenders is how much they will get in return for lending their money. The interest rate determines this.
Figure 2. The supply of loanable funds, StudySmarter Originals
Figure 2. shows the supply curve for loanable funds. As the interest rate gets higher, more money is available for borrowing. That is to say, when the interest rate is higher, more people will hold from their consumption and provide funds to borrowers. That is because they get a higher return from lending their money. When the interest rate is at 10%, lenders are willing to lend $100K. However, when the interest rate is at 3%, lenders were willing to supply only $75 K.
When the interest rate is low, the return you get from lending your money is also low, and instead of lending it, you could be investing them in other sources such as stocks, which are riskier but give you higher returns.
Notice that the interest rate causes movement along the supply curve, but it doesn’t shift the supply curve. The supply curve for loanable funds can shift only due to external factors, but not because of a change in the interest rate.
Loanable funds market graph
The loanable funds market graph represents the market that brings borrowers and lenders together. Figure 3. depicts the loanable funds market graph.
Figure 3. The loanable funds market graph, StudySmarter Originals
The interest rate on the vertical axis refers to the price of borrowing or lending money. The equilibrium interest rate and quantity occur when the demand for loanable funds and the supply of loanable funds intersect. The above graph shows that the equilibrium occurs when the interest rate is r*, and the quantity of loanable funds at this rate is Q*.
The equilibrium market can change when there are shifts in either demand or supply of loanable funds. These shifts are caused by external factors that influence either the demand or the supply.
Loanable funds demand shift
The demand curve for loanable funds can shift either to the left or to the right.
Figure 4. A shift in demand for loanable funds, StudySmarter Originals
Factors that cause shifts in the loanable funds’ demand curve include:
Change in perceived business opportunities
The expectations about the future returns of certain industries and the entire market, in general, play an important role in the demand for loanable funds. Think about it, if you want to establish a new start-up, but after doing some market research, you find out that low returns are expected in the future, your demand for loanable funds will drop. Generally, when there are positive expectations about returns from business opportunities, the demand for loanable funds will shift to the right, causing the interest rate to increase. Figure 4. above shows what happens when the demand for loanable funds shifts to the right. On the other hand, whenever there are low returns expected from business opportunities in the future, the demand for loanable funds will shift to the left, causing the interest rate to decrease.
Government borrowings
The amount of money that governments need to borrow plays an important part in the demand for loanable funds. If the Governments are running budget deficits, they will have to finance their activities by borrowing from the loanable funds market. This causes the demand for loanable funds to shift to the right, resulting in higher interest rates. Conversely, if the Government is not running a budget deficit, then it will demand less loanable funds. In such a case, the demand shifts to the left, resulting in decreased interest rate.
A large Government deficit comes with consequences for the economy. Holding everything else equal, when there’s an increase in budget deficits, the government will borrow more money, which will increase the interest rates.
The increase in the interest rates also increases the cost of borrowing money, making investments more expensive. As a result, the investment spending in an economy will fall. This is known as the crowding-out effect. Crowding out suggests that when there’s an increase in budget deficits, it will cause investments to fall in an economy.
Loanable funds supply shift
The supply curve for loanable funds can shift either to the left or to the right.
Figure 5. illustrates what happens when the supply curve for loanable funds shifts to the left. You can notice that the interest rate increases and the quantity of money in the loanable funds market decreases.
Figure 5. Shifts in supply for loanable funds, StudySmarter Originals
When there’s a tendency amongst people to save more, it will cause the supply of loanable funds to shift to the right, and in return, the interest rate decreases. On the other hand, when there is a change in private savings behaviour to spend rather than save, it will cause the supply curve to shift to the left, resulting in a rise in interest rate. Private savings behaviours are prone to many external factors.
Imagine that the majority of people start to spend more on clothes and going out on the weekends. To fund these activities, one would have to reduce their savings.
Capital Flows
As financial capital determines the amount borrowers have available for borrowing, a change in capital flows can shift the supply of loanable funds. When there are capital outflows, the supply curve will shift to the left, which results in a higher interest rate. On the other hand, when a country experiences capital inflows, it will cause the supply curve to shift to the right, resulting in lower interest rates.
Loanable funds market model
The loanable funds market model is used to simplify what happens in the economy when borrowers and lenders interact. The loanable funds market model is an adjustment of the market model for goods and services. In this model, you have the interest rate instead of the price, and instead of a good, you have money being exchanged. It basically explains how money is bought and sold between lenders and borrowers.
Main ideas behind the loanable funds' theory
At the core of the loanable funds' theory stands the idea that saving is equal to the investment in an economy. In other words, there are borrowers and savers meeting in a market where savers are the suppliers of funds and borrowers are those who demand these funds.
Interest rate is used to determine the equilibrium in the loanable funds market. The level at which the interest rate is in an economy dictates how much borrowing and saving there will be.
Loanable funds market examples
To illustrate what happens in the loanable fund market, let’s consider Sam, who makes $40,000 a year. The market interest rate is 5%, and at this market rate, Sam only saves $5,000 and uses the remainder of his income to spend on consumption.
Sam earns $250 (5%x5,000) a year from the $5,000 he decided to save. The question then becomes who pays Sam $250. Well, when Sam saved $5,000, someone went to the loanable funds market to borrow it. There they were used by Jack, who is a property developer. Jack needs to pay his interest of $250 (determined by the market interest rate, 5%) to Sam for using his money for a year.
What happens to Sam’s savings when the interest rate increases to 10%? Sam can now make much more from saving his money rather than spending it on consumption. Because of this, Sam increases his savings from $5,000 to $10,000. The money he will be making at a 10% interest rate is equal to $1,000 (10%x$10,000).
The loanable funds market - Key takeaways
- When an economy is closed, investment is equal to the national savings, and when there is an open economy, investment is equal to the nationwide savings and capital inflow from other countries.
- The loanable funds market is the market that brings savers and borrowers together.
- The interest rate in the economy dictates the price at which savers and borrowers agree to either lend or borrow.
- The demand for loanable funds consists of borrowers looking to finance new projects they want to engage in.
- The Supply of loanable funds consists of lenders willing to lend their money to borrowers in exchange for a price paid on their money.
- Factors that cause shifts in the loanable funds’ demand curve includes: changes in perceived business opportunities, government borrowings, etc.
- Factors that cause the supply of loanable funds to shift include private savings behaviour, and capital flows.
- The loanable funds market model is used to simplify what happens in the economy when borrowers and lenders interact.
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