Private Investment and Real Interest Rates

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  • 0:05 The Need for Expansion
  • 0:54 The Market for Loanable Funds
  • 2:20 Private Investment
  • 3:33 Demand & Supply of…
  • 8:16 Government Policies
  • 10:16 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

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.

Private Investment

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.

The downward-sloping demand curve depicts lower demand for loanable funds
Downward Sloping Demand Curve

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.

The supply of loanable funds available is shown with an upward-sloping supply curve
Upward Sloping Supply Curve

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.

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