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Supply of Loanable Funds

Supply of Loanable Funds

Assume that your local bank increases the interest paid on your savings account from 2% to 6%. Would you save more money and cancel some dinners with friends? How do people save, and where does that money go? Who pays the interest you get on your savings account? You will be able to answer all these questions and many more once you read our explanation on Supply of Loanable Funds.

Supply of Loanable Funds Definition

You may ask, where does the supply of loanable funds definition come from? Let's start from the beginning.

The ability of households to borrow and save through an efficient financial system is what provides long-term economic growth. The ability to efficiently channel funds from lenders to borrowers that will be later used for investments that generate value through establishing a new startup or investing in new projects provides people with more jobs and goods and services in the economy.

Think about it, when Elon Musk came up with the idea of Tesla to bring down CO2 emissions from gas guzzlers and save the planet, Elon Musk needed a loan so he could start building new electric vehicles. How much this loan would have been possible had it not been for savers who were willing to lend Elon Musk money.

All these transactions between borrowers and savers occur in the loanable funds market, which is one of the main financial markets in an economy. Savers and borrowers come together in this market to exchange loanable funds. The price at which the transaction occurs is the interest rate.

Loanable funds from a savers' point of view refer to the total amount of income households have decided to save and lend out rather than use it for their consumption.

From a borrower's point of view, loanable funds refer to all the money households and investors have decided to borrow to finance new projects.

The point at which borrowers and savers agree to exchange their funds provides the interest rate, and this rate serves as both the return on savings and the cost of borrowing money.

Like any other market in the economy, the market for loanable funds is controlled by supply and demand.

The demand for loanable funds comes from individuals and companies that want to take out loans to undertake investments.

Families taking out mortgages to purchase brand new houses are one example of the demand for loanable funds. It also includes businesses taking out loans to purchase new equipment or construct factories. The need for readily available loanable cash is driven, in both instances, by investment activity.

We have an entire explanation that covers Demand in the Loanable Funds Market. Don't miss out!

On the other hand, the supply for loanable funds is the part of income households choose to save or in other words 'supply' in return for the interest paid for using their money.

People who have some disposable income leftover and decide to store it or lend it out are the source of the available loanable money. This lending can occur directly, such as when a household purchases a bond from a company, or it can take place indirectly, such as when a household deposit in a bank, which then uses the funds to make loans. Both of these scenarios involve transferring money from the household to the company.

Saving is the source of the available supply in the loanable funds market. Saving, which provides loanable funds, includes private and national savings. Private saving comes from individuals and households, whereas national saving comes from the government's budget.

For a broader explanation of the loanable funds market, have a look at our article - Loanable Funds Market.

Determinants of the Supply of Loanable Funds

One of the main determinants of the supply of loanable funds is the interest rate. The interest rate provides the return individuals receive for loaning their money to borrowers.

supply loanable funds market studysmarterFigure 1. Supply in the Loanable Funds Market, StudySmarter Originals

Figure 1 shows the supply of loanable funds. Notice, that as the interest rate increases, the quantity of loanable funds supplied increases. This means that there is a positive relationship between the interest rate and the supply of loanable funds.

To better understand why there is a positive relationship between the supply of loanable funds and the interest rate, let’s consider an example.

Let’s consider how Anna would save when the interest rate is at 4% and when the interest rate is at 8%.

Anna has $10,000 available to save at the end of each year. If Anna saves when the interest rate is 4%, she will receive $400 at the end of the year.

However, when the interest rate is 8%, Anna makes $800 from lending her money - double the amount!

This would incentivize Anna to save more to be able to invest her money at 8% compared to what she would choose to invest at 4%.

More loanable funds are supplied as a result as this occurs across all individuals in an economy.

The Source of the Supply of Loanable Funds

What is the source of the supply of loanable funds? The answer is - individuals' savings.

Saving is the portion of income that households and individuals do not consume. Saving is the source of supply for loanable funds.

Let's consider savings at a macroeconomic level.

Remember that the gross domestic product (GDP) refers to the total revenue in an economy and the total spending on the goods and services produced.

The gross domestic product, often denoted as Y, is broken down into four distinct categories of spending: consumption (C), investment (I), government purchases (G), and net exports (NX).

The equation for GDP is written as:

Let's first assume that it is a closed economy.

An economy is closed if it does not trade or engage with any other economies

In particular, a closed economy does not participate in the international commerce of commodities and services.

Additionally, a closed economy does not participate in international borrowing or lending.

Since a closed economy does not participate in international commerce, the amount of imported and exported goods equals zero. As a result, the net exports (NX) component of GDP is equal to zero.

In this scenario, we may express Y as the following equation:

According to this equation, the gross domestic product (GDP) equals the sum of the total consumption, investment, and government purchases.

Deducting C and G from both sides of this equation will allow us to determine what this identity may teach us about the financial markets.

We get the following equation:

The total income in the economy is shown on the left side of this equation (Y - C - G), which is the amount left over after accounting for consumption and government spending.

In other words, when you deduct government spending and individual consumption from the national income you get national savings. Nationwide savings is the total amount of savings in an economy or the portion of GDP that is saved and not spent.

Let's further denote national saving with S.

The above equation could be re-written as:

This means that national saving provides the main source of investment in a closed economy.

National saving equals private savings and government savings

Savings and Tax Rate

Another important part to consider is the tax rate.

For private savings, the income available for savings is after the individual used all of their income for paying taxes and paying for consumption.

Tax means revenue for the government. So the public saving is equal to the total revenue minus total spending.

We've seen that the national saving is equal to the investment in a closed economy, where there is no international borrowing or saving.

However, investment equals national savings and capital inflows coming from other countries in an open economy.

Supply of Loanable Funds Shifters

When the interest rate changes, there is a movement along the supply of loanable funds curve, but what about the shifters of the supply of loanable funds? Other external factors such as private savings behavior and capital inflows cause the supply for loanable funds curve to shift.

Supply of Loanable Funds Curve

How does the shift in the supply of loanable funds curve look like?

supply loanable funds Shift in the supply of loanable funds studysmarter

Figure 2. Shift in the supply of loanable funds, StudySmarter Originals

Figure 2 shows an example of a leftward shift of the supply in the loanable funds market. Holding demand constant, a leftward shift in the supply of loanable funds causes the interest rate to increase and the total quantity of loanable funds available to drop. On the other hand, a rightward shift in the supply for loanable funds would cause the interest rate to drop and the quantity of loanable funds to increase.

Private Savings Behavior

The average percentage of a family's income put aside for savings differs across countries. Private saving behaviors strongly affect the loanable funds market by changing the supply of loanable funds. When you have a higher saving rate, the supply for loanable funds will shift to the right lowering the interest rate, which would cause more investment to take place in an economy.

Let's assume that the government changes the tax code to provide more incentives for people to save. The tax on interest income significantly lowers the future payout that will arise from present savings, reducing the incentive for individuals to save money.

When the government lowers the tax on interest income, individuals will have the incentive to save more as they can earn more in the future. This would shift the supply for loanable funds curve to the right, resulting in a lower interest rate in the economy.

Capital Inflows

Capital inflows refer to the money that is invested in an economy by foreign investors. Capital inflows affect the amount of financial capital that is available for borrowing.

When foreign investors are bullish on a country's long-term economic growth and start investing in the country, more money will be available for borrowing, thus, shifting the supply of loanable funds to the right, resulting in a lower interest rate.

To better understand the economic impact of these shifts, check out our explanation that covers The Equilibrium in the Loanable Funds Market.

Supply in the Loanable Funds Market - Key Takeaways

  • The supply for loanable funds is the part of income that households choose to supply in return for interest
  • The supply of loanable funds shows a positive relationship between the interest rate and the quantity of loanable funds supplied
  • In a closed economy, in which there is no borrowing or lending, national saving is equal to the sum of public savings and private savings
  • In an open economy, investment equals national savings plus net capital inflow
  • Factors that shift the supply of loanable funds such as private savings behavior and capital inflows change the equilibrium interest rate and equilibrium quantity

Frequently Asked Questions about Supply of Loanable Funds

External factors such as private savings behavior and capital inflows cause the supply for loanable funds to shift.

Supply of loanable funds comes from individuals' savings.

Private savings behavior and capital inflows

A rightward shift in the supply for loanable funds causes the interest rate to drop. A leftward shift in the supply of loanable funds causes the interest rate to increase.

Because the supply of loanable funds shows a positive relationship between the real interest rates and the quantity of loanable funds supplied.

Final Supply of Loanable Funds Quiz

Question

What does loanable funds refer to?

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Answer

Loanable funds refer to the total amount of income households have decided to save and lend out rather than using it for their consumption from a savers' point of view. From a borrower's point of view, loanable funds refer to all the money households and investors have decided to borrow to finance new projects.

Show question

Question

Explain the interest rate in the loanable funds market?

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Answer

The point at which borrowers and savers agree to exchange their funds provides the interest rate, and this rate serves as both the return on savings and the cost of borrowing money.

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What controls the loanable funds market?

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Answer

Like any other market in the economy, the market for loanable money is controlled by supply and demand.

Show question

Question

Explain the demand for loanable funds.

Show answer

Answer

The demand for loanable funds comes from individuals and companies that want to take out loans to undertake investments.

Show question

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Explain the supply for loanable funds.

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Answer

The supply for loanable funds is the part of income households chooses to supply in return for interest paid for using their money. 

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Question

What is the source of the available supply for loanable funds?

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Answer

Savings.

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Question

What is one of the main determinants of the supply in the loanable funds market?

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Answer

One of the main determinants of the supply of loanable funds is the interest rate. 

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Question

What's the relationship between the quantity of loanable funds supplied and the interest rate?

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Answer

There is a positive relationship between quantity of loanable funds supplied and the interest rate. As the interest rate increases, the number of loanable funds also supplied increases.

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Question

What is saving?

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Answer

Saving is the portion of income that households and individuals do not consume. 

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What does it mean for saving to be equal to investment in a closed economy?

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Answer

That means that national saving provides the main source of investment in a closed economy.

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What is national savings equal to?

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Answer

National saving equals private savings and government savings.

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What is investment equal to in an opened economy?

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Answer

Investment equals national savings and capital inflows coming from other countries in an open economy.

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Question

What happens when there is a rightward shift in the supply for loanable funds?

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Answer

Holding demand constant, a rightward shift in the supply for loanable funds causes the interest rate to drop and the quantity of money to increase. 

Show question

Question

What happens when there is a lefttward shift in the supply for loanable funds?

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Answer

A leftward shift in the supply of loanable funds causes the interest rate to increase and the total quantity of loanable funds available to drop.

Show question

Question

What factors cause the supply for loanable funds to shift?

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Answer

Private savings behavior and capital inflows.

Show question

Question

Explain how private savings behavior influences the supply in the loanable funds market.

Show answer

Answer

The average percentage of a family's income put aside for savings differs across countries. Private saving behaviors strongly affect the loanable funds market by shifting the supply of loanable funds. When you have a higher saving rate, the supply for loanable funds will shift to the right lowering the interest rate, which would cause more investment to take place in an economy.

Show question

Question

Explain how capital inflows influence the supply in the loanable funds market.

Show answer

Answer

Capital inflows refer to the money that is invested in an economy by foreign investors. Capital inflows affect the amount of financial capital that is available for borrowing.


When foreign investors are bullish on a country's long-term economic growth and start investing in the country, more money will be available for borrowing, thus, shifting the supply of loanable funds to the right, resulting in a lower interest rate.

Show question

Question

All these transactions between borrowers and savers occur in the ______ market

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Answer

loanable funds

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The price at which the transaction of loanable funds occurs is the ______


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interest rate

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Like any other market in the economy, the market for loanable funds is controlled by ______ and ______.


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supply

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 the _____ of loanable funds is the part of income households choose to save


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supply

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When a household deposits money in the bank, they are a part of...

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the supply

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Private savings come from _____, whereas national savings come from _____.

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households; government

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There is a ______ relationship between the interest rate and the supply of loanable funds.

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positive

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True or False: In an open economy, investment equals national savings plus net capital inflow

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True

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True or False: In a closed economy, in which there is no borrowing or lending, national saving is equal to the sum of public savings and private savings

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True

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True or False: The supply for loanable funds is the part of income that households choose to supply in return for interest

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True

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True or False: The supply of loanable funds shows a positive relationship between the interest rate and the quantity of loanable funds supplied

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True

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Captial inflows shift the supply curve...

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to the right

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Capital outflows shift the supply curve...

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to the left

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higher private savings will shift the supply curve...

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to the right

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lower private savings will shift the supply curve...

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to the left

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The ______ for loanable funds comes from individuals and companies that want to take out loans to undertake investments. 


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demand

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The point at which borrowers and savers agree to exchange their funds provides the...

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interest rate

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