When you borrow money, where does that money come from and why is it available? In this lesson, you’ll learn about the market for loanable funds, where savers deposit money and entrepreneurs borrow money to finance private investment.
The Need for Expansion
When Bob the business owner signs up new customers for his weekly lawn service, he needs to borrow money to invest in a new mower. I’m not talking about a tiny little household lawn mower. I’m talking about a large, ginormous commercial mower with heated seats, gold plating and anti-lock brakes. When Bob needs a new mower, he goes to the market for loanable funds to accomplish this. From Bob’s perspective, he just gets onto his Harley and drives to the bank to sit down with a loan officer. We’ll call him Sam, but his name has been changed to protect the innocent. Although Bob may not think about it when he’s filling out the paperwork for a loan, he’s participating in the market for loanable funds.
The Market for Loanable Funds
In the market for loanable funds, banks facilitate the connection between saving and investing. In this market, the demanders are the entrepreneurs who borrow money to invest into physical capital, such as machinery and equipment, so they can produce products and services. The suppliers are the savers who deposit money into savings accounts at banks like the one Bob is talking to in order to finance a new mower for his business.
While Bob’s in the office with the loan officer, he happens to see Margie the cake baker come into the lobby of the bank to deposit a check into her savings account. The bank serves an important purpose by connecting savers like Margie, who want to earn a return on their money, with borrowers like Bob, who are willing to pay a price for the use of that money in their businesses. Bob doesn’t even realize it at the time, but when his loan for a new mower is approved, some of the money comes from Margie’s savings account. In essence, Margie’s savings is helping to fund Bob’s business. If he knew this, he’d probably send her some flowers or pass out refrigerator magnets to his customers to advertise Margie’s cake bakery.
Whenever a person or business spends money on capital equipment, buildings or machinery for use in producing products or performing services, economists call it gross private domestic investment. It’s also referred to as private investment for short.
Private investment is an important part of the economy, and has a major impact on the employment situation, because businesses that expand usually need more workers. When private investment goes way down, unemployment tends to go up. For example, in 2006, gross private domestic investment represented 17.3% of the economic output of the United States. By 2009, it had dropped to only 11.2%. At the same time, unemployment went from 4.4% in December of 2006 all the way up to 10% during 2009. As you can see, private investment went way down, while unemployment went way up.
So how does this market work? Let’s begin with the demand side of the market.
The Demand for Loanable Funds
The demand for loanable funds depends on two things: the interest rate that entrepreneurs will pay to borrow money and the amount of profit they expect to make from investing.
Businesses like Bob’s compare the real interest rate they must pay to the bank with the rate of profit that they expect to earn on the money they borrow. For example, let’s say that Bob can borrow $10,000 to buy a high-end, jet-powered, disco-inspired commercial mower and some matching shades, all at a real interest rate of 8%. Since it’s a loan, that means he’ll make monthly payments to the bank for a certain number of years. With the size of these payments, suppose that Bob can afford to invest into one mower, which will empower one of his workers to mow more lawns. As long as Bob can use this new mower to earn more than his monthly payment, he’ll make a profit by borrowing money for his business.
Now let’s say that the real interest rate was 5% instead of 8%. When Bob goes to the loan officer at his bank to discuss expansion, he finds that he can invest into two mowers instead of one, because the payments would be lower at an interest rate of 5%. As you can see, Bob’s investment into his business depends on what real interest rates are and also how much profit he can generate. The lower the real interest rate, the more profit he can generate, and the more his investment can be. This dynamic plays out across the whole economy. The lower the real interest rate is, the higher the quantity demanded of loanable funds.
Expectations also play an important role in this market. What do I mean by that? If investors feel that business conditions will deteriorate in the future, then the demand for loanable funds and the real interest rate will go down. Economists illustrate demand in this market using a downward-sloping demand curve.
The Supply of Loanable Funds
Now let’s talk a little more about the supply side of the market for loanable funds. The supply of loanable funds in the economy is affected by the real interest rate, by disposable income and by the wealth level. So let’s talk about what those three things mean.
For example, if Margie earns $70,000 per year in her cake business, and she spends $65,000 per year, that means she has $5,000 left over. Margie deposits this extra amount into a savings account at her bank, which then gets loaned out to borrowers. Although Margie may only earn an interest rate of, say, 2% to 5%, the bank will loan out most of her money at a higher interest rate, like 8% or 10%, for example. The money Margie deposits into her private savings account increases the supply of loanable funds.
So the most important determinant of saving is the real interest rate. The higher the real interest rate, the more people like Margie want to save, and the greater the quantity supplied of loanable funds.
But other things affect the supply of loanable funds as well. The higher that disposable income is in the economy, the more loanable funds will be supplied. For example, if Margie earned $100,000 per year instead of $75,000 per year, she could save even more in her savings account, and that means more funds can be loaned out at the bank.
Finally, the more wealth people have, the more that they will save some of their wealth in savings accounts. Let’s say that in addition to saving out of her income, Margie has $200,000 of wealth. She has decided to keep some of that wealth in savings accounts in the bank.
All three of these things, the real interest rate, the level of disposable income and the amount of wealth determine how much supply is in the market for loanable funds. Economists illustrate this supply with an upward-sloping supply curve.
This market works according to the laws of supply and demand. That means that at the intersection of the supply and demand, there is an equilibrium interest rate and equilibrium quantity.
Government policies can strongly influence the market for loanable funds. Let’s look at a few real-world examples, beginning with the supply side of the market.
Suppose the government provides a tax incentive for people to save more. Specifically, they lower the taxes that people pay on savings accounts. What would this do to the supply for loanable funds?
If people have an added incentive to save, then they would save more money. For example, instead of saving $5,000 of her income, suppose that Margie decides to save $10,000 instead. Economists would say it this way: the quantity supplied of loanable funds would go up. With a larger supply and the same demand, this would lead to a lower interest rate.
Now let’s look at two examples from the opposite part of the market – from the demand side.
Suppose the government provides a tax incentive for businesses to invest. When this happens, more businesses spend money on capital equipment, or other things that help them produce the products they sell. Economists would say it this way: increased investment leads to a greater demand for loanable funds, shifting the demand curve to the right. This leads to a higher real interest rate.
Finally, suppose the government spends more and borrows more. Economists would describe the consequences this way: greater government borrowing leads to a greater demand for loanable funds. This causes the demand curve to shift to the right, resulting in a higher real interest rate. Economists call this crowding out because the higher interest rates caused by government borrowing crowds out individuals and businesses who can’t afford to invest at the higher rates.
Here are the key points that we talked about in this lesson. In the market for loanable funds, banks facilitate the connection between saving and investing. In this market, the demanders are the entrepreneurs who borrow money to invest into physical capital like machinery and equipment, what economists call private investment. The suppliers are the savers who deposit money into savings accounts at the banks, hoping to earn interest.
The demand for loanable funds depends on two things: the real interest rate that entrepreneurs will pay to borrow money and the amount of profit they expect to make from investing.
Expectations also play an important role in this market. If investors feel that business conditions will deteriorate in the future, the demand for loanable funds and the real interest rate will go down. Economists illustrate demand in this market using a downward-sloping demand curve.
The supply of loanable funds is how much people are saving in the economy. The most important determinant of saving is the real interest rate. However, other things affect it, including the level of disposable income and the amount of wealth. These determine how much supply is in the market for loanable funds. Economists illustrate supply with an upward-sloping supply curve.
Government policies that influence the supply of loanable funds include fiscal policies such as lower taxes on savings. Government policies that influence the demand for loanable funds include investment tax credits and government budget deficits financed with borrowed money.
Once you finish this lesson you’ll be able to:
- Explain the market for loanable funds
- Define private investment
- Determine what factors influences the demand for loanable funds
- Understand how the supply of loanable funds fluccuates
- Explain how government policies can influence the supply of loanable funds