Imagine that, all of a sudden, most people in the economy want to buy a house. To do that, they would have to borrow money from the banks. However, there is only a certain amount of funds the bank can lend. How would the bank react to such an increase in demand for loans? How does that impact the overall interest rate in the economy? You will be able to answer all these questions once you read our explanation on the demand in the loanable funds market. Keep going!
Demand in the Loanable Funds Market Meaning
Is the meaning of demand in the loanable funds market different from the demand in a regular market?
Let's abstract from the markets for a moment and think of the term demand in general.
Demand plays a vital role in each economy. There's demand for various factors in an economy, depending on the market and the sector we are referring to. There is demand for automobiles, groceries, and financial assets. Similarly, there is demand for loanable funds which means that there is a market for loanable funds too!
Loanable funds market is a market where different types of loans are being traded.
Before we dive into the meaning of the demand in the loanable funds market, let's talk about the characteristics of the loanable funds market.
The Loanable Funds Market Characteristics
The loanable funds market is one of the financial markets in an economy that unites borrowers and savers. It is one of the most important financial markets in an economy as it determines the interest rate.
The interest rate, which is determined by the equilibrium of the loanable funds market, directly impacts how much people will choose to save and how much people will want to borrow.
The demand for loanable funds comes from everyone in the economy who wants to borrow money to use it for financing purposes.
Let's assume that Anna wants to buy a new house in the countryside as she doesn't want to keep renting an apartment downtown. Anna doesn't have all the funds she needs to buy a new house. She needs to borrow some money. Anna goes to the loanable funds market and borrows some money which she'll pay back throughout a specified period. This means that Anna is providing the demand for loanable funds. It is important to note that Anna has to pay for the funds she borrows, and the price she pays for borrowing them and the price she pays for it is known as the interest rate.
Demand Determinantns in the Loanable Funds Market
The demand for loanable funds is determined by the interest rate and has an inverse relationship with it. The interest rate in the loanable funds market can be expressed both in nominal and real terms. That is to say, you could have the interest rate that captures future price increases or an interest rate that doesn't.
As a borrower or an investor, you would actually care how much you make in real terms, adjusting the inflation's impact on your money. That way, you can calculate by how much your purchasing power would increase.
However, most of the loans are expressed in nominal terms as no one can really predict the inflation rate in the future. For that reason, the interest rate of the loanable funds market you see in the real world is the nominal interest rate.
The interest rate is of great importance as it basically shows borrowers the price they pay for their money. If the price they pay for borrowing gets really high, the demand for loanable funds will drop. That is because borrowers would have to pay a lot of money back, and it wouldn't always be worth it. On the other hand, when the interest rate is low, the cost of borrowing money is relatively cheaper, which then pushes people to demand more money.
Interest rate in the loanable funds market is the price you pay for taking out a loan
Demand in the Loanable Funds Market Curve
Figure 1 below shows the demand curve in the loanable funds market. It illustrates the inverse relationship between the quantity demanded of loanable funds and the interest rate. When the interest rate increases from r1 to r2, the quantity of money demanded drops from Q1 to Q2. On the other hand, when the interest rate decreases from r1 to r3, the quantity of money demanded increases from Q1 to Q3.
Fig 1. - Demand for loanable funds
Notice here when the interest rate changes, there is a movement along the demand curve. Do not confuse the movement along the demand curve with a shift in demand curve. For the demand for loanable funds to shift other factors rather than the interest rate need to change.
Demand From Businesses in the Loanable Funds Market
The demand for loanable funds comes from individuals or businesses who want to borrow money. But why would a business or a person borrow money? How do companies decide that they want to take a loan and whether it's worth it?
Businesses borrow money to finance any new projects that they are undertaking. They should consider that they have to pay the price for investing in any project. If the project they are investing in isn't worth it and is not going to give anything back to the business, then why take a loan and pay interest on it? Rate of return on investment is the tool that the businesses use to determine whether a project is worth undertaking.
Companies are significantly concerned with the rate of return. Rate of return is basically the profit a company makes as a percentage of the cost. The cost in this case would be the amount of interest they pay. So if the project's cost gets really high, there's not much profit to be made.
The formula for the rate of return is as follows:
A business will demand a loan at a percentage rate that is equal to or smaller than the rate of return.
For example, let's consider a company that wants to buy land for 100,000. The price of the land is estimated to grow to 105,000 the following year. What is the maximum interest rate the company would settle for?
Based on the formula:
The rate of return for the company is 5%. So the company will demand a loan that has an interest rate strictly less than 5% to make any profit. A loan that has a higher interest than this amount will cause the company to incur losses, as they will get to pay more than what they receive from the project they've invested in.
Rate of return on investment is the tool that the businesses use to determine whether a project is worth undertaking.
Causes of Shifts in the Demand for Loanable Funds
Let's take a look at some of the causes of shifts in the demand for loanable funds. A change in the factors other than the interest rate would cause the demand for loanable funds to shift.
It's important to know that the equilibrium in the loanable funds market results from the interaction of demand and supply forces. When they are equal, the equilibrium in this market is formed, resulting in a certain amount of interest rate and quantity of loanable funds demanded.
Holding the supply for loanable funds constant, a rightward shift in the demand curve would result in a higher interest rate, and more quantity of loanable funds demanded. On the other hand, a leftward shift in the demand for loanable funds would result in lower interest rates, and lower quantity of loanable funds demanded.
Figure 2 below shows a rightward shift in the demand for loanable funds from D to D'. The equilibrium interest rate changes from r* to r1 and the quantity demanded of loanable funds increases from Q* to Q1.
Fig 2. - Rightward shift in demand for loanable funds
Factors that shift the demand for loanable funds include:
- investment tax credit
- changes in perceived business opportunities
- government borrowings
Investment Tax Credits
Investment tax credits serve as tools the federal government uses to incentivize business investment. This works by allowing individuals to deduct a certain amount of money used for investment from their taxes.
This shifts the demand curve for loanable funds to the right. The reason for that is that when the amount of money individuals can deduct from taxes is higher, they will want to demand more money from the loanable funds market, shifting the demand curve to the right. On the other hand, when the amount of money individuals can deduct from their taxes is lower, the demand for loanable funds will shift to the left.
Changes in Perceived Business Ppportunities
To understand how changes in perceived business opportunities shift the demand for loanable funds, let's imagine you're in the year 2020 before Bitcoin went from $5,000 to a record high of $68,000 - more than ten times growth in your investment. If you knew such information, wouldn't you want to borrow money to invest all of it in Bitcoin and become a millionaire? This would cause your loanable funds demand to shift to the right. In general, whenever there are positive expectations about certain business opportunities, the demand for loanable funds will shift to the right, resulting in a higher interest rate. On the other hand, when there are negative expectations about future business opportunities, the demand for loanable funds will shift to the left, resulting in a lower interest rate.
Government Borrowing
Whether the government is running a budget deficit or a budget surplus, it does impact the demand in the loanable funds market. When the government is running a budget deficit, it will have to borrow more money from the public to finance its deficit. This will result in a rightward shift in the demand for loanable funds. On the other hand, if the government is running a surplus, then the demand for loanable funds will shift to the left.
The law of Demand in the Loanable Funds Market
The law of demand in the loanable funds market states that the quantity of funds demanded will decrease as the interest rate increases and vice versa. The law of demand in the loanable funds market is similar to the law of demand in any other market. Instead of price, you have interest rates, and instead of quantity of goods, you have the quantity of loanable funds.
Demand in the Loanable Funds Market - Key takeaways
- The demand for loanable funds comes from everyone in the economy who wants to borrow money to use it for financing purposes.
- The demand for loanable funds has an inverse relationship with the real interest rate in the economy.
- Factors that shift the demand for loanable funds include:
- investment tax credit
- changes in perceived business opportunities
- government borrowings
- Factors that shift the demand for loanable funds also change the equilibrium interest rate and the equilibrium quantity of loanable funds
- The demand in the loanable funds market is used to explain the effects of government spending on interest rates.
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