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.
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.
Figure 1. Supply in the Loanable Funds Market
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?
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.
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
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