Why do interest rates in the economy change? What are some of the determinants that cause interest rates in an economy to change? What happens when everyone starts holding cash instead of consuming or investing? If you wanYou will be able to answer all these questions once you read our explanation of the equilibrium in the loanable funds market.
Equilibrium in the Loanable Funds Market meaning
To understand the equilibrium in the loanable funds market meaning, let's consider how the economy works. An economy has many financial markets; one of those is the loanable funds market. Everyone who wants to save money is considered to be part of this market, and everyone who wants to borrow money will utilize this market to get a loan from someone else. Therefore, loanable funds are all income individuals have decided to save and lend out rather than utilize for their consumption. This includes the amount of money investors have borrowed to support new investment initiatives. There is only one interest rate in the market for loanable funds, which serves as both the rate of return on savings and the cost of borrowing.
Like all other markets in the economy, the loanable funds market is regulated by the laws of supply and demand. The point where the demand and supply for loanable funds intersect forms the equilibrium in the loanable funds market.
The equilibrium point in the loanable funds market is the point where the demand for loanable funds and supply for loanable funds intersect.
The equilibrium in the loanable funds market is extremely important for any economy. It determines the interest rate and the amount of money that flows into the economy. When the equilibrium interest is high, less money will flow into the economy. On the other hand, more money will flow into the economy with low-interest rates.
The equilibrium interest rate does not change unless there is a shift in the demand or supply for loanable funds.
Equilibrium in the Loanable Funds Market determinants
Equilibrium in the loanable funds market determinants include the supply and the demand for loanable funds.
The supply of loanable cash is provided by individuals who have excess income that they want to preserve and lend out. A household's lending may occur directly when the household, for example, purchases a bond from a company, or indirectly, as when the household puts a deposit in a bank, which utilizes the money to make loans to other individuals and businesses. Savings are the source of loanable supply in each of these scenarios.
The demand for loanable funds originates from individuals and businesses that desire to borrow money to finance capital projects. Families that take out mortgages to purchase new houses are included in this demand. It also covers companies who take out loans to buy new equipment or construct factories.
The interest rate is the cost of borrowing money. It shows the difference between the amount borrowers pay for loans and the amount lenders get as a return on their savings.
Given that a high-interest rate makes borrowing more costly, the number of loanable funds requested decreases proportionally as the interest rate increases. Also, in the same way, that an increased interest rate makes saving more appealing, the number of loanable funds available increases proportion to an increase in the interest rate.
The demand curve for loanable funds is sloping downward, while the supply curve for loanable funds is sloping up.
The equilibrium interest rate in the Loanable Funds Market
The equilibrium interest rate in the loanable funds market occurs when the quantity of money demanded is equal to the quantity of money supplied.
Fig. 1 - Equilibrium interest rate
Figure 1 shows the equilibrium interest rate in the loanable funds market. The variable r* is the natural rate of interest, meaning the rate that the market settles at, rather than one dictated. It is similar to Q*, the natural quantity of loanable funds. The market will reach these points naturally as prices, or quantities too low or high will not clear the market, which pressures the market to an equilibrium where all buyers and sellers at this price participate. It's important to understand the reasoning why the equilibrium in the loanable funds market occurs.
If the interest rate were to go below the equilibrium level and enter a state of disequilibrium, the number of loanable funds provided would be less than the number of loanable funds demanded, which is a shortage. As a consequence of a lack of loanable capital, lenders will have so many buyers they will have an incentive to hike the interest rates they charge. A higher interest rate would encourage people to save, increasing the number of loanable funds available. A higher interest rate will discourage people from borrowing money for investment purposes, decreasing the number of loanable funds demanded. That is the self-correcting nature of the market, a disruption occurs, and then a shortage pushes price and quantity back towards equilibrium.
What happens if the interest rate is above the equilibrium? If the interest rate exceeds the equilibrium level, the number of loanable funds provided will exceed the number of loanable funds demanded, creating a surplus. To attract the few available consumers, lenders would compete with one another, driving interest rates down. Consequently, the interest rate approaches the equilibrium level, which is the point at which the supply and demand for loanable funds will equalize.
Shifts in the equilibrium interest rate
We've previously stated that shifts in the equilibrium interest rate can happen only when there is a shift in the demand for loanable funds or the supply for loanable funds. A change in interest rate does not change the equilibrium interest rate; it simply causes a movement along with the demand or the supply curve.
Let's consider some of the reasons why the demand for loanable funds might shift.
Change in perceived business opportunities.
The demand for loanable money is influenced significantly by expectations about the future returns of specific sectors and the overall market in general.
Consider the following scenario:
You wish to invest in the EV sector, and you would like to borrow some money for your project with the expectation that there will be higher returns than the cost of borrowing. Say the interest rate dropped to 6%, and your project has an expected return on investment (ROI) of 12%, so you begin your project.
If everyone spotted this opportunity of a 6% interest rate and started borrowing money, it would cause the money demand curve to shift to the right, increasing the equilibrium interest rate. This causes the interest rate to increase to 10%, at which point investors are skeptical of your project as the profit margin shrunk greatly.
In the example above, we see that the interest rate is used to determine investment feasibility. However, that can change when market demand drives the interest rate upwards. This example would assume a flexible market interest rate. If a fixed interest rate were negotiated, it would likely be higher than the market price.
Generally speaking, when there are high expectations for the returns on business prospects, the demand for loanable money shifts to the right, leading the interest rate to rise.
Fig. 2 - Rightward shift in the demand for loanable funds
Figure 2 depicts a perceived increase in the business opportunity, which causes the demand for loanable money to change to the right (D1) from its previous position(D). This increase in demand causes the quantity to change (from Q* to Q1). Because supply doesn't shift, the increased demand drives up the interest rate (from r* to r1), encouraging a greater supply of loanable funds.
Conversely, anytime poor future returns on business possibilities are anticipated, demand for loanable money will shift to the left, resulting in a decrease in the equilibrium interest rate.
Government borrowings
In addition to perceived business opportunities, government borrowings play an important role in influencing the demand for loanable funds. You should be aware that the government resorts to borrowing from the public when running a budget deficit. As the government increases the amount of borrowing from the public, it will cause the demand for loanable funds to shift to the right, increasing the equilibrium interest rate. Therefore, you can brace for some high-interest rates ahead whenever you see that the government is running a budget deficit.
In contrast, if the government does not have a budget deficit, it will request less loanable money. Demand swings to the left in such a situation, reducing the interest rate.
Therefore, the equilibrium interest rate factors that would cause a shift in supply for loanable funds include private saving behavior and capital flows.
Private saving behavior
The tendencies of people to consume or save play an important role in the equilibrium interest rate. Generally, the equilibrium interest rate will be higher when you have countries characterized by significant consumption (few savings). On the other hand, when you have countries where most people save for their retirements and consume less, the equilibrium interest rate in these countries will be lower.
Fig. 3 - Leftward shift in the supply for loanable funds
Figure 3 represents a leftward shift in loanable funds supply (from S to S'). This supply decrease can result from an increase in consumer spending that leads to fewer consumers saving money. When the supply shifts to the left, the demand is still high and will compete, causing the interest rate to increase (from r* to r1). Because the competition from demand drove up the interest rate, the demand at the higher price is lower, which lowers the quantity of money flowing into the economy. That means that investment and new projects will occur less as the total loanable funds in the market have decreased.
Capital flows
Capital flows refer to the amount of financial capital available to borrowers. Because financial capital influences the number of loanable funds that borrowers have available to them, a change in capital flows might cause the supply of loanable funds to fluctuate.
Generally, there will be a higher equilibrium interest rate when capital outflows. The supply for loanable funds will be shifting to the left, resulting in a decrease in supply and demand. On the other hand, the equilibrium interest rate will be lower with capital inflows as the supply for loanable funds changes to the right, increasing supply and demand.
Concept of equilibrium in the Loanable Funds Market
Concept of equilibrium in the loanable funds market includes the idea that the supply and demand interest to form the equilibrium interest rate. The supply and demand model for loanable funds demonstrates that financial markets function similarly to other markets in the economy. For example:
In the milk market, the milk price adjusts such that the amount of milk provided equals the quantity of milk sought, resulting in a balanced market.
There is unintentional coordination in the behavior of dairy producers with the actions of milk consumers; this can be attributed to the invisible hand we hear so much when studying economics.
Once you understand that saving represents the supply of loanable money and investment represents the demand for loanable funds, we can see how the invisible hand coordinates saving and investment activities. When the interest rate is adjusted to maintain a balance between supply and demand in the market for loanable funds, it helps to coordinate the behavior of individuals who want to save (the suppliers of loanable funds) with the behavior of those who want to invest (the demanders of loanable funds).
Equilibrium in the Loanable Funds Market equation
To find equilibrium in the loanable funds market equation, let's denote the demand for loanable funds as LD and the supply of the loanable funds as LS. The demand and supply must be equal for the loanable funds market to be in equilibrium.
Therefore
Assume that the money demand is equal to LD=400-25r and the supply of loanable funds is
LS=75r. What is the equilibrium interest rate?
LD=LS
400 - 25r = 75 r
400 = 75r + 25r
400 = 100r
r = 4%
In the example above, we see a formula for the supply and demand of loanable funds; these formulas vary depending on various economic factors, and the numbers used here are arbitrary. However, it is still applicable to finding the equilibrium interest rate, as all that needs to be done is set the two formulas equal to each other. After some simple algebra, we find an interest rate of 4%.
The loanable funds market plays a big part in the economy, affecting both the total investment and business ventures and the availability for consumers to make big purchases such as housing. Market economists can better understand what projects and investments are feasible under a market's current interest rate by understanding the loanable funds.
Equilibrium in the Loanable Funds Market - Key takeaways
- Equilibrium in the loanable funds market describes how savers and borrowers interact.
- The demand for loanable funds drops as the interest rate increases; hence there is an inverse relationship between the quantity demanded and interest rates.
- There is a positive relationship between the interest rate and the quantity supplied of loanable funds.
- Equilibrium in the loanable funds market occurred when the quantity demanded equals the quantity supplied.
- Market forces will bring interest rates to equilibrium when there's disequilibrium in the loanable funds market, either a surplus or a shortage.
- The equilibrium interest rate and the equilibrium quantity of funds change when the demand or supply of loanable funds shifts.
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