The market for loanable funds is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.
Funds that Finance Investment
The funds that finance investment are from household saving, the government budget surplus, and international borrowing.
Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X - M). Combining shows that C + S + T = C + I + G + (X - M), which can be rearranged to show how investment is financed:
I = S + (T - G) +(X - M).
This formula shows that investment is financed using private saving, a government budget surplus, (T - G) and borrowing from the rest of the world,(X - M).
· The sum of private saving, S, plus government saving, (T - G), is national saving.
· If we export less than we import, (X - M) is negative and we borrow (M - X) from the rest of the world.
· If we export more than we import, (X - M) is positive and we loan (X - M) to the rest of the world.
The Real Interest Rate
The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.
The Demand for Loanable Funds
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment.
Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit.
The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.
· The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate.
· Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism.
The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.
The Supply of Loanable Funds
The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving.
The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.
When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping.
Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward.
Equilibrium in the Market for Loanable Funds
As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied. In the figure, the equilibrium real interest rate is 5 percent and the equilibrium quantity of loanable funds is $1.6 trillion.
Changes in Demand and Supply
Changes in either demand or supply change the real interest rate and the price of financial assets.
· If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase.
· If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase.
· Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.
Equilibrium in the Market for Loanable Funds