The Interest Rate
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.