The market for loanable funds determines the equilibrium interest rate and quantity of loans being provided within an economy.
The equilibrium interest rate and quantity of loanable funds is determined by the intersection of the supply and demand curve, illustrated in the diagram below. For the market of loanable funds, the supply curve is determined by the aggregate level of savings within the economy. The demand curve is determined by the amount of borrowers within the economy.
- The interest rate is the same for borrowers and lenders.
- There is only one lending institution who charges the one interest rate (thus there are no share markets etc. which is unrealistic but a good simplification to get a base understanding).
- The economy is a closed economy - i.e there is no interactions with overseas countries.
Determinants of demand
The demand for loanable funds is determined by the amount that consumers and firms desire to invest. Some examples are:
- Firms upgrading machinery for their factories
- Consumers purchasing a house
- Government building a road
The demand curve for loanable funds slopes downwards. It slopes downwards because when the interest rate decreases, it becomes cheaper to borrow money. For example, consumers are more likely to borrow money to buy a house when interest rates are lower as it will be cheaper to make repayments.
Determinants of supply
The quantity of savings within an economy are determined by consumers and the governments preference towards savings. Typically, we assume that governments savings are fixed and do not depend on the interest rate. However, we assume that the amount of savings that a household saves depends positive on the interest rate. The higher the interest rate, the more that they would be willing to save.
The quantity of supply is determined by the quantity of savings. The quantity of savings is determined as:
S = Y - C - G
Y is the total income of the country
C is how much of the country spends on consuming goods
G is how much the government spends on consuming goods
Savings should be thought as of the money left over after the government and people have consumed goods.
From this we can infer that anything which causes consumers to spend less on consumption will lead to a higher level of savings and also anything which leads to the government reducing its spending (thus, them saving their tax revenue) will also increase the supply of savings.
Shifters in demand
What factors shift demand to the left - a reduction in demand?
- Increased tax on investment earnings
A negative shock to demand causes the demand curve to shift to the left. This reduces the interest rate and decreases the quantity of loanable funds.
What factors shift demand to the right - an increase in demand?
- Increased tax on consumption
- Tax benefits for savings
When the economy experiences a positive shock to demand, this causes the demand curve to shift to the right. This causes the interest rate to increase and the quantity of loanable funds to also increase.
Shifters in supply
What factors shift supply to the left - a reduction in supply?
- Government running a deficit (this is called 'crowding out' affect because the government crowds out the private sector)
A negative supply shock shifts the supply curve to the left. This causes the interest rate to increase and the quantity of loanable funds to decrease.
What factors shift supply to the right - an increase in supply?
A positive supply shock causes the supply curve to shift to the right. This causes the interest rate to decrease and the quantity of loanable funds to decrease.