Loanable Funds: Definition & Theory

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  • 0:00 Definition of Loanable Funds
  • 1:16 Market Price for…
  • 3:07 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Just like most goods and services in a market economy, there is a market where buyers and sellers meet to lend and borrow money. In this lesson, you'll learn about loanable funds and the theory behind it. A short quiz follows.

Definition of Loanable Funds

Loanable funds is the sum total of all the money people and entities in an economy have decided to save and lend out to borrowers as an investment rather than use for personal consumption. The theory of loanable funds uses a classical market analysis to describe the supply, demand, and interest rates for loans in the market for loanable funds.

The supply of loanable funds comes from people and organizations, such as government and businesses, that have decided not to spend some of their money, but instead, save it for investment purposes. One way to make an investment is to lend money to borrowers at a rate of interest.

People and organizations seek loans, also for investment purposes. Businesses, for example, will seek loans to pay for capital assets, such as a factory or machinery. Individuals often seek loans to invest in the purchase of a house. They hope not only to have a place to live, but also an asset that will increase in value over time. Consequently, the desire to finance investments through borrowing makes up the demand for loanable funds.

Market Price for Loanable Funds

The law of supply and demand is applicable in the market for loanable funds. You can consider the interest rate a lender earns, or a borrower must pay, as the price for the loan. Supply, as we have stated above, is simply the amount of savings in the market that provides the money to fund the loans. Demand is the level of investment seeking financing. As the interest rate on loanable funds increases, it becomes more expensive to borrow, and the quantity of funds demanded will decrease. On the other hand, as the interest rate for loanable funds increase, the supply of loanable funds also increases because higher interests rates makes saving more financially attractive.

Eventually, the interest rate for loanable funds will reach equilibrium, where demand for loanable funds equals the supply offered for investment. If the interest rate is lower than the interest rate at equilibrium, then the amount of loanable funds available is less than the demand for them. As a result, lenders will increase the interest they charge on loans until the rate reaches the equilibrium point, as the supply of funds increases due to increasing interest rates, and the demand decreases because of the increased lending costs.

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