The Loanable Funds Market

• Loanable Funds market (loans)::

  • How much money in the form of loans consumers, businesses, and government are requiring

    • Determined by expectation of return on investment

• Real interest rate::

  • The “price of borrowing money”

  • with loanable funds, use real instead of nominal b/c loans are usually taken over a longer period of time

  • Real interest rate = nominal interest rate - inflation rate

• Demand for loans

  • Follows the law of demand like any other good/service (downsloping)

  • Represents the amount of loans being demanded by consumers, producers, and government

• Supply of loans

  • Follows the law of supply like any other good/service (upsloping)

  • In a closed economy:

    • Supply in closed economy = national savings

    • national savings = public + private savings

  • In an open economy

    • Supply in open economy = national savings + net capital inflow (money coming in from foreign investors)

• Equilibrium

  • Occurs when the interest rate is set where quantity supplied = quantity demanded

Disequilibrium in the loanable funds market

• Left graph:

  • Real interest rate is below the equilibrium

    • Shortage of loans

      • demand will go up and supply will go down

      • borrowing will be more cheap (high demand)

      • less payoff for saving

        • People won’t keep as much money in the bank so the amount available to loan out decreases (low supply)

    • Must increase interest rate from IR2 to IRe

• Right graph:

  • Real interest rate is above the equilibrium

    • Surplus of loans

      • demand will go down and supply will go up

      • borrowing will be more expensive (low demand)

      • more payoff for saving

        • People will keep more money in the bank so the amount available to loan out increases (high supply)

    • Must decrease interest rate from IR2 to IRe

Changes in demand of loanable funds: shifted by changes in return on investment

• Left graph:

  • Higher expected return on investment, economy doing well, higher income, etc

    • Demand for loans increases (shifts right)

    • Equilibrium interest rate increases

• Right graph:

  • Lower expected return on investment, recession, people losing jobs, etc

    • Demand for loans decreases (shifts left)

    • Equilibrium interest rate decreases

Changes in supply of loanable funds: shifted by changes in savers’ behavior

• Saving refers to people keeping their money in banks instead of spending it

• Left graph:

  • Saving increases

    • supply for loans increases (shifts right)

    • Equilibrium interest rate decreases

• Right graph:

  • Saving decreases

    • supply for loans decreases (shifts left)

    • Equilibrium interest rate increases