The Market for Loanable Funds

For the economy as a whole, savings
always equals investment spending

In a closed economy, savings is
equal to national savings

In an open economy, savings is equal
to national savings plus capital
inflow
Equilibrium Interest Rate

The Loanable funds market is a
hypothetical market that illustrates
the market outcome of the demand
for funds generated by borrowers
and the supply of funds provided by
lenders
Equilibrium Interest Rate

The price that is determined in the
loanable funds market is the interest
rate, r.

It is the return that a lender receives
for allowing borrowers the use of a
dollar for one year, calculated as a
percentage of the amount borrowed
Equilibrium Interest Rate

The rate of return on a project is the
profit earned on the project
expressed as a percentage of its
cost.

A business will want a loan when the
rate of return on its project is greater
than or equal to the interest rate
Interest
rate
12%
4
Demand for loanable funds, D
0
$150
450
Quantity of loanable
funds
(billions of dollars)
Interest
rate
Supply of loanable funds, S
12%
4
0
$150
450
Quantity of loanable
funds
(billions of dollars)
Equilibrium Interest Rate

Savings incur an opportunity cost
when they lend to a business; the
funds could instead be spent on
consumption

Whether a given individual becomes
a lender by making funds available to
borrowers depends on the interest
rate received in return
Equilibrium Interest Rate

The equilibrium interest rate is the
interest rate at which the quantity of
loanable funds supplied equals the
quantity of loanable funds demanded
Interest
rate
12%
r*
Projects with rate of
return
8% or greater are
funded.
Offers not accepted from
lenders who demand
interest
rate of more than 8%.
8
Projects with rate of
return
less than 8% are not
funded.
4
Offers accepted from
lenders willing to lend at
interest rate of 8% or less.
0
$300
Q*
Quantity of loanable
funds
(billions of dollars)
Equilibrium Interest Rate

1.
2.
Match up of funds is efficient
The right investments get made: the
investment spending projects that
are actually financed have higher
rates of return than those that do not
get financed
The right people do the saving: the
potential savers who actually lend
funds are willing to lend for lower
interest rates than those who do not
Shifts of the Demand for
Loanable Funds
Changes in perceived business
opportunities
1.

2.
Business opportunities in the 90s with
the Internet
Changes in government’s borrowing
 Changes in budget deficits can shift the
demand curve
An Increase in the Demand for Loanable Funds
Interest
rate
. . . leads to
a rise in the
equilibrium
interest rate.
r2
r1
An increase
in the
demand
for loanable
funds . . .
Quantity of loanable
funds
(billions of dollars)
Shifts of the Demand for
Loanable Funds

Fact that an increase in the demand
for loanable funds leads, other things
equal, to a rise in the interest rate has
one especially important implication:
 Beyond concern about repayment, there

are other reasons to be wary of
government budget deficits
Crowding out occurs when a government
deficit drives up the interest rate and leads
to reduced investment spending
Shifts of the Supply of Loanable
Funds
1.
Changes in private savings behavior: Between
2000 and 2006 rising home prices in the United
States made many homeowners feel richer,
making them willing to spend more and save
less This shifted the supply of loanable funds
to the left.
2.
Changes in capital inflows: The U.S. has
received large capital inflows in recent years,
with much of the money coming from China
and the Middle East. Those inflows helped fuel
a big increase in residential investment
spending from 2003 to 2006. As a result of the
worldwide slump, those inflows began to trail
off in 2008.
Interest
rate
r1
. . . leads to
a fall in the
equilibrium
interest rate.
r2
An increase
in the supply
of loanable
funds . . .
Quantity of loanable
funds
(billions of dollars)
Inflation & Interest Rates
Anything that shifts either the supply
of loanable funds curve or the
demand for loanable funds curve
changes the interest rate.
 Historically, major changes in interest
rates have been driven by many
factors, including:

 changes in government policy.
 technological innovations that created
new investment opportunities.
Inflation & Interest Rates
However, arguably the most
important factor affecting interest
rates over time is changing
expectations about future inflation.
 This shifts both the supply and the
demand for loanable funds.
 This is the reason, for example, that
interest rates today are much lower
than they were in the late 1970s and
early 1980s.

Inflation & Interest Rates

Real interest rate =
nominal interest rate - inflation rate

In the real world neither borrowers
nor lenders know what the future
inflation rate will be when they make
a deal. Actual loan contracts,
therefore, specify a nominal interest
rate rather than a real interest rate.
Inflation & Interest Rates

According to the Fisher effect, an
increase in expected future inflation
drives up the nominal interest rate,
leaving the expected real interest rate
unchanged.

The central point is that both lenders
and borrowers base their decisions
on the expected real interest rate
The Fisher Effect
Nominal
interest
rate
S10
14%
E10
D10
S0
4
E0
D0
0
Q*
Quantity of loanable
funds
The Interest Rate in the Short
Run
As explained before, using the liquidity
preference model, a fall in the interest
rate leads to a rise in investment
spending, I, which then leads to a rise in
both real GDP and consumer spending,
C
 The rise in real GDP doesn’t lead only a
to a rise in consumer spending but it
also leads to a rise in savings, at each
stage of the multiplier process, part of
the increase in disposable income is
saved

The Interest Rate in the Short
Run
How much do savings rise?
 Savings-investment spending identity
states that total savings in the economy
is always equal to investment spending
 When a fall in interest rate leads to
higher investment spending, the
resulting increase in real GDP generates
exactly enough additional savings to
match the rise in investment spending

The Interest Rate in the Short
Run
In the short run, the supply and
demand for money determine the
interest rate, and the loanable funds
market follows the lead of the money
market
 When a change in the supply of
money leads to a change in the
interest rate, the resulting change is
real GDP causes the supply of
loanable funds to change as well

Interest Rates in the Long Run

In the long run, changes in the
money supply don’t affect the
interest rate
Interest Rates in the Long Run

What determines the interest rate in
the long run is supply and demand
for loanable funds

In the long run, the equilibrium
interest rate is the rate that matches
the supply of loanable funds with the
demand for loanable funds when real
GDP equals potential output