The market of loanable funds:
The market for loanable funds shows the interaction between
borrowers and lenders that helps determine the market interest rate and the
quantity of loanable funds exchanged.
The market for loanable funds consists of two actors, those
loaning the money (savings from households like us) and those borrowing the
money (firms who seek to invest the money).
Those loaning the money are the suppliers of loanable funds, and would
like to see a higher return on their savings.
This means that higher interest rates are going to motivate people to
either start saving, or save more. This
is why there is a positive relationship (upward trend) between the loanable
funds and the real interest rate for the supply of loanable funds curve.
The second curve represents those borrowing loanable funds
and is called the demand for loanable funds line. People who are interested in borrowing money
are more likely to do so if the opportunity cost of borrowing money is low
(meaning a low real interest rate). Another
way to think of it is to analyze how good the return on an investment will
be. If the return on your investment is
5% and the interest rate is 6%, then you won’t borrow the money. However, if your return rises to 7% then now
you will make money on the deal because you are making 7% and only paying 6% to
borrow the money. This is why more
people will demand loanable funds the lower the real interest rate gets.
You can see in the above graph that the supply of loanable
funds and the demand of loanable funds cross and give us an equilibrium
interest rate of I* and an equilibrium quantity of loanable funds at Q*.
Crowding out in the loanable funds market:
Let’s say that the government decides to increase government
purchases, which will increase the demand for loanable funds. This will shift the demand curve right,
resulting in a higher interest rate and a higher quantity of loanable
funds. The magnitude of the shift right
is the increase in the amount of government purchases a movement from Q* to Q’
(if all of it is borrowed). The
difference between the new Q’’ and Q’ shows much private investment is crowded
out due to the idea of crowding out theory (that firms invest less when the
government runs a deficit).
