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Using the loanable funds theory, discuss how interest rates are determined.

Question:

Using the loanable funds theory, discuss how interest rates are determined.

Loanable Funds Theory:

In the study of economics, the loanable funds theory is a concept used to evaluate different interest rates in the market. According to this theory, different interest rates are established by the demand and supply of loanable amounts of money, or 'loanable funds.' Loanable funds are all of the forms of money or capital that are available for lending credit, including loan instruments, bonds, and deposits.

Answer and Explanation:

According to the loanable funds theory, interest rates are determined by the amount of supply or demand of money. As the supply of money goes up, interest rates will go down. As the demand for loanable funds increases, interest rates also increase.

This theory can be demonstrated by the actions of central banks and the money supply. To encourage economic activity, central banks, like the Federal Reserve in the United States, will lower their target interest rates. This in turn increases the demand for cheaper loanable funds and causes economic activity to increase.

Another key part of the loanable funds theory is related to the supply of loanable funds by savings deposits. A country of 'savers' will not necessarily cause interest rates to increase because the demand variable also plays into the way that interest rates are determined.


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Loanable Funds: Definition & Theory

from Introduction to Business: Homework Help Resource

Chapter 25 / Lesson 29
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