The Financial System III

The Market for Loanable Funds

We have seen that the value of total saving must equal the value of total investment Opens in new window, but we have not yet discussed how this equality is actually brought about in the financial system.

We can think of the financial system Opens in new window as being composed of many markets through which funds flow from lenders to borrowers:
  • the market for certificates of deposit at banks,
  • the market for shares,
  • the market for bonds,
  • the market for managed fund shares and so on.

For simplicity, we can combine these markets into a single market for loanable funds.

Market for loanable funds is the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.

In the model of the market for loanable funds, the interaction of borrowers and lenders determines the market interest rate and the quantity of loanable funds exchanged.

Firms can also borrow from savers in other countries. For the remainder of this post, we will assume there are no interactions between households and firms in Australia and those in other countries.

Demand and Supply in the Loanable Funds Market

The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects, such as building new factories or engaging in research and development of new products.

In determining whether or not to borrow funds, firms compare the return they expect to make on an investment with the interest rate they must pay to borrow the necessary funds.

For example, if Bunnings Opens in new window is considering opening several new stores and expects to earn a return of 10 percent on its investment, the investment will be profitable if it can borrow the funds at an interest rate of 5 percent but will not be profitable if the interest rate is 15 percent.

In Figure I, the demand for loanable funds is downward sloping because the lower the interest rate the more investment projects firms can profitably undertake, and the greater the quantity of loanable funds they will demand.
Figure I. The Market for Loanable Funds Figure I. The Market for Loanable Funds | Source: the Internet

The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving.

When households save they reduce the amount of goods and services they can consume and enjoy today.

The willingness of households to save rather than consume their incomes today will be determined in part by the interest rate they receive when they lend their savings.

The higher the interest rate the greater the reward for saving and the larger the amount of funds households will save.

Therefore, the supply curve for loanable funds in Figure I is upward sloping to reflect the fact that the higher the interest rate the greater the quantity of saving supplied.

A distinction must be made between the nominal interest rate and the real interest rate.

  • The nominal interest rate is the stated interest rate on a loan.
  • The real interest rate corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate.

Because both borrowers and lenders are interested in the real interest rate they will receive or pay, equilibrium in the market for loanable funds determines the real interest rate rather than the nominal interest rate.

Explaining Movements in Saving, Investment and Interest Rates

Equilibrium in the market for loanable funds determines:
  • The quantity of loanable funds that will flow from lenders to borrowers each period.
  • It also determines the real interest rate that lenders will receive and that borrowers must pay.

A shift in either the demand curve or the supply curve will change the equilibrium interest rate and the equilibrium quantity of loanable funds.

If, for example, the profitability of new investment increases due to technological change Opens in new window, firms will increase their demand for loanable funds.

Figure II (indicated Figure 16.7 from the source) shows the impact of an increase in demand in the market for loanable funds.

Figure II. An Increase in the Demand for Loanable Funds Figure II. An Increase in the Demand for Loanable Funds | Source: the Internet

As in the markets for goods and services, an increase in demand in the market for loanable funds shifts the demand curve to the right. In the new equilibrium the interest rate increases from i1 to i2, and the equilibrium quantity of loanable funds increases from L1 to L2.

Notice that an increase in the quantity of loanable funds means that both the quantity of saving by households and the quantity of investment by firms have increased.

Increasing investment increases the capital stock and the quantity of capital per hour worked, helping to increase economic growth Opens in new window.

We can also use the market for loanable funds to examine the impact of a government budget.

Recall that if the government runs a budget deficit it reduces the total amount of saving in the economy Opens in new window.

Suppose the government increases spending, which results in a budget deficit.

We illustrate the effects of the budget in Figure III by shifting the supply curve for loanable funds to the left.

Figure II. An Increase in the Demand for Loanable Funds Figure III. An Increase in the Demand for Loanable Funds | Source: the Internet

In the new equilibrium the interest rate is higher and the equilibrium quantity of loanable funds is lower.

Running a deficit has reduced the level of total saving in the economy and, by increasing the interest rate, has also reduced the level of investment spending by firms.

By borrowing to finance its budget deficit the government will have crowded out some firms that would otherwise have been able to borrow to finance investment.

Crowding out refers to a decline in private expenditure as a result of an increase in government purchases.

A government budget surplus has the opposite effect to a deficit. A budget surplus increase the total amount of saving in the economy, shifting the supply of loanable funds to the right.

In the new equilibrium the interest rate will be lower and the quantity of loanable funds will be higher.

We can conclude that a budget surplus increases the level of saving and investment.

In practice, however, the impact of government budget deficits and surpluses on the equilibrium interest rate is relatively small.

This finding reflects in part the importance of global saving in determining the interest rate. However, this small effect on interest rates does not imply that we can ignore the effect of deficits on economic growth.

Also, if government spending puts upward pressure on inflation, a country’s central bank may increase interest rates to reduce inflationary pressures, which will reduce private investment.

Further, paying off government debt in the future will require higher taxes, which can depress economic growth.