Shawn has a masters of public administration, JD, and a BA in political science.
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.
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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.
On the other hand, if interest rates are above the equilibrium level, the supply of loanable funds will be higher than demand. This will cause lenders to lower interest rates to compete for borrowers and more borrowers will enter the market as money becomes cheaper to borrow. Eventually, supply will equal demand and the interest rate will stabilize. This chart depicts the loanable fund market at equilibrium, where S equals supply, I equals investment, and r is the rate of interest (see video).
Loanable funds constitute the savings available in an economy that can be used to provide loans for investment. The theory of loanable funds is a market theory. Under the theory, savings provides the supply of loanable funds, and demand is provided by the desire of individuals and businesses to invest through borrowing. The loanable funds market follows the general law of supply and demand where an increase in supply tends to lower interest rates if demand remains unchanged and an increase in demand tends to increase interest rates if supply remains unchanged. The market price for interest rates will reach equilibrium and stabilize, where supply of loanable funds equals the demand for them.
Where Does All this Money Come From?
Modern society has made taking out a loan a fairly common event. People can go to their local banks and apply for a loan, but where does that money come from? Loanable funds are used in the economy as a type of investment, which is subject to supply and demand, to be available to those seeking funding.
After reviewing this lesson, you should be able to define loanable funds and describe how supply and demand dictate its conditions.
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Loanable Funds: Definition & Theory
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