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Microeconomics/Resource Markets/The Market for Loanable Funds

Resource Markets

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The Market for Loanable Funds

The market for loanable funds brings together individual savers and firms trying to borrow in order to purchase capital. The market for loanable funds can be thought of as a market for financial capital, which in turn funds the physical capital used in production.
Firms rely on loanable funds to purchase physical capital used in the production process. Capital is another factor of production, but when economists refer to capital markets, they generally mean the markets for the money used to buy the physical capital or the trucks and machines and such themselves. This market for financial capital is often referred to as the market for loanable funds, and is the interaction between individuals trying to save and earn a return and firms trying to borrow in order to purchase capital. The demand for loanable funds is the amount of money that firms want to borrow to fund purchases of physical capital.
Individuals provide funds in the form of savings, while banks charge interest for loaning funds. Equilibrium in the loanable funds market, where supply and demand intersect, determines the interest rate, i*.
Like other markets, the market for loanable funds has a demand side and a supply side, and it tends toward an equilibrium price and quantity. The supply of loanable funds (the amount of money available in the market for loans) comes from individual (and, in a slightly more complicated model, government) savings. In other words, individuals supply loanable funds when they put their money in the bank, buy stocks or bonds, and so on, and these funds are used by others to finance the purchase of machines and other inputs to production. As such, the demand side in the market for loanable funds represents firms looking for funds to finance investment to continue and/or expand their businesses. A firm may need a loan to build an additional factory, creating demand. If there is enough supply, it can build the factory and hopefully grow its business to create more capital.

The Interest Rate

The interest rate can be thought of as either the return on saving, the cost of borrowing, or the price of money borrowed. The market for loanable funds determines the equilibrium interest rate in an economy.

In the market for loanable funds, the price is the interest rate, cost of borrowing money, expressed as a percentage of the amount borrowed; or, equivalently, the return on savings. As a result, the market for loanable funds determines the equilibrium interest rate in an economy (with some help from the Federal Reserve, the central bank that determines monetary policy and decides the interest rates at which banks loan each other money). The interest rate can be thought of in two ways: on the supply side, the interest rate is the return on savings (the money gained by the saver when they deposit money into a bank), and on the demand side, the interest rate is the cost of borrowing.

Shifts in the supply and demand of loanable funds can explain why interest rates in an economy change over time. Specifically, interest rates increase when the supply of loanable funds decreases or the demand for loanable funds increases, and interest rates decrease when the supply of loanable funds increases or the demand for loanable funds decreases.

What factors affect how much people in an economy want to save? One factor is the interest rate. In general, higher interest rates encourage higher levels of saving and vice versa, so the supply of loanable funds generally slopes upward. For example, if a bank offers five percent each quarter on what customers have saved in a savings account, more customers would likely keep their money in savings because they would be profiting greatly: five cents for every dollar each quarter. But if a savings account offers .25% interest, it is not as lucrative for the saver, thus fewer customers would save money in their accounts. The supply of loanable funds also shifts when individuals' tastes for saving change. For example, if individuals realize they need more money for retirement or they are looking to buy a house in the future, the supply of loanable funds will shift to the right.

On the demand side, higher interest rates discourage borrowing and vice versa, so the demand for loanable funds generally slopes downward. The demand for loanable funds shifts based on a firm's optimism and expectations of profitability. Specifically, demand for loanable funds will shift to the right when businesses are more optimistic, and vice versa.

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