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? The loanable funds market is a crucial concept in economics that explains how the supply and demand of funds determine interest rates. In this article, we will explore the definition of the loanable funds market, examine a graph that illustrates its workings, and provide examples of how it operates in the real world. By the end, you will have a clear understanding of how this model works and its significance in the economy.
What is the Loanable Funds Market?
In its simplest form, the loanable funds market is where borrowers meet lenders. It's an abstract market representing all the places and manners - like banks, bonds, or even a personal loan from a friend - where savers provide funds (capital) that borrowers can use for investment, home purchase, education, or other purposes
Loanable Funds Market Definition
The loanable funds market is an economic model used to analyze the market equilibrium for interest rates. It involves the interaction of borrowers and lenders where the supply of loanable funds (from savers) and demand for loanable funds (from borrowers) determine the market interest rate.
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.
Consider a scenario where individuals are saving more money in their bank accounts. These additional savings increase the pool of loanable funds. As a result, a local business looking to expand might now get a loan at a lower interest rate because the bank has more funds to lend out. This example represents the dynamics of the loanable funds market, where changes in savings can affect interest rates and the availability of loans for investment.
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. Read the next section to learn how these shifts affect our model.
How Does the Loanable Funds Market Model Work?
To understand how the loanable funds market model works, we need to study the shifts in the demand and supply curves which are instrumental in understanding this market's dynamism. In the following sections, we will explore what causes these shifts, examining how changes in business perspectives, government borrowing, household wealth, time preferences, and foreign investment can alter the landscape of the loanable funds market. It is through understanding these shifts that we truly grasp the intricate operations of this market model.
Loanable Funds Demand Shifts
The demand curve for loanable funds can shift to the left or 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 to the left or 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
Factors that cause the supply of loanable funds to shift include:
Private savings behaviour
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 Theory
The loanable funds market theory is used to simplify what happens in the economy when borrowers and lenders interact. The loanable funds market theory 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. 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 there examples of how loanable funds market works in the real world.
Saving for Retirement
Let's imagine that Jane is a diligent saver who regularly deposits a portion of her income into her retirement account, such as a 401(k) or an IRA. Though primarily intended for her future, these funds enter the loanable funds market. Here, they're lent out to borrowers like businesses or other individuals. The interest Jane earns on her retirement savings represents the price of lending her funds in this market.
Business Expansion
Consider a company like ABC Tech. It sees an opportunity to expand its operations and needs capital to do so. It turns to the loanable funds market to borrow money. Here, the company encounters lenders like banks, mutual funds, or private individuals who, lured by the promise of interest payments, are willing to lend their saved funds. ABC Tech's ability to borrow for expansion exemplifies the demand side of the loanable funds market.
Government Borrowing
Even governments participate in the loanable funds market. For example, when the U.S. government issues Treasury bonds to finance its deficit, it essentially borrows from this market. Individuals, corporations, and foreign entities who buy these bonds are lending their funds, contributing to the supply side. The bond's interest rate (yield) represents the market's price.
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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