Introduction to Loanable Funds Market

The market for loanable Funds is where borrowers and lenders get together. As with other markets, there is a supply curve and a demand curve. In the loanable funds framework, the supply represents the total amount that is being lent out at different interest rates or the amount being saved in the economy while the demand curve represents the total demand for borrowing at any given interest rate. Lending in the loanable funds framework takes many forms. Any time a person saves some of his or her income, that income becomes available for someone to borrow. Money saved in a bank savings account is part of the supply of loanable funds. If you deposit money in a bank rather than spending it, the bank can then lend the money to a person or business that wants to borrow. In this way you are supplying funds into the loanable funds framework (and the business or person borrowing the funds is contributing to the demand for loanable funds).

For example, if a person has an income of $20,000, spends $18,000 on goods and services and puts $2,000 into a savings account, the supply of loanable funds will increase by $2000. This $2000 is now available for someone else to borrow. The quantity of loanable funds supplied increases as the interest rate increases. When deciding on how much to save, an individual looks at the benefit that they can get by saving. As the interest rate increases, the benefit that you get through saving increases (higher interest earnings) and this tends to encourage people to save more. In general, as the interest rate increases, the quantity of loanable funds supplied (the aggregate willingness to save) will increase. This is why the supply curve in the loanable funds framework slopes upwards (in a graph with interest rates on the vertical axis and the quantity of loanable funds on the horizontal axis).

For example, if you have an extra $5000 in your checking account and you see that interest rates are at 1%, you can only earn $50 (.01*$5000=$50) in interest by saving the money for a year. You instead decide to spend the money now on a new computer and stereo system. On the other hand, if interest rates are at 15%, you can earn $750 by saving the money for one year (.15*$5000=$750) and now you decide to save the money. The higher interest rates have encouraged you to save and the amount of loanable funds supplied has increased. The demand for loanable funds represents a desire to borrow resources at different interest rates. Borrowing occurs mainly in order to meet Investment demand. For example, businesses borrow in order to build new factories or buy new machines for their workers and individuals borrow to houses. The demand for loanable funds is decreasing as the interest rate increases. From the point of view of a borrower (the source of demand in the loanable funds framework), as interest rates increase, the cost of borrowing goes up and the person (or business) is less likely to borrow. Therefore, as interest rates increase, the quantity of funds demanded decreases. This is why the demand curve slopes downward.

Equilibrium in the Loanable Funds Market

In the loanable funds framework, the interest rate adjusts until supply is equal to demand. The supply and demand curves will cross at exactly one point, determining the equilibrium interest rate. At this equilibrium, the total amount that is being lent out (the quantity supplied) is equal to the total amount that is being borrowed (the quantity demanded). If the interest rate is higher or lower than this equilibrium point there will be either more demand than supply (excess demand) or less demand than supply (excess supply) in the market. If interest rates are higher than the equilibrium where supply equals demand, there will be excess supply in the market. With high interest rates, a lot of people are encouraged to save rather than to spend, causing the quantity of loanable funds supplied to be larger.

The high interest rates also mean that borrowers pay a high cost to borrow causing borrowing and the quantity demanded to be smaller. The interest rate will fall as lenders compete by offering funds at a lower rate. Excess demand exists when interest rates are too low. A very low interest rate discourages savings (smaller quantity supplied) due to the low return that is earned. At the same time, a low interest rate tends to attract a lot of borrowing (larger quantity demanded) The interest rate will rise to equilibrium as borrowers compete for the loanable funds.