✅Loanable fund theory of interest
The loanable funds market constitutes funds from:
1) Banks and financial institutions
2) Stock market
3) Bond market
4) Securities market
These funds are saved by people/companies and supplied to the markets above.
These funds are then also demanded by people/companies for investment purposes.
The demand for loanable funds (for investment purposes) is dependent on
1) The real interest rate
2) Future expected profits.
Firms will demand loanable funds for investment only when the future expected profits are greater than the real interest rate.
We generally assume future expected profits are fixed, and so as the real interest rate goes down, the demand for loanable funds goes up and vice-versa.
Demand for loanable funds diagram
Relation between interest rates and profit expectations:
Interest rate “r” being the same, if profit expectations go up, demand for lonable funds will also go up, as from DLF to DLF1.
Interest rate “r” being the same, if profit expectations go down, demand for lonable funds will also go down, as from DLF to DLF2.
There are two possible exceptions to the general condition that lower interest rates increase the demand for loanable funds and vice versa.
If profit expectations are very low, then even a low rate of interest may not be incentive enough to raise the demand for loanable funds and
If profit expectations are high, then even a high rate of interest may not be disincentive enough to lower the demand for loanable funds, meaning the demand for loanable funds will still be high in-spite of high interest rates.
Supply of loanable funds:
Loanable funds are supplied out of
Government budget surplus
Of the three people’s savings are the main source of the supply of loanable funds.
The supply of loanable funds has a positive (direct) relationship with the real interest rate.
As “r” goes up, the opportunity cost of not saving goes up, and so people save more, raising the supply of loanable funds.
Moreover as “r” goes up from say 4% to 8% per annum, people will forgo/sacrifice present consumption and thus increase savings, which is the same as increasing the supply of loanable funds from 2 to 6 trillion dollars (see diagram).
Other factors affecting the supply of loanable funds are:
Disposable income: As disposable income goes up, consumption goes up, but generally not by the whole amount of the increase in income.
So savings also go up, and so does the supply of loanable funds.
As wealth increases, so does the supply of loanable funds.
The real rate of interest being the same, as disposable income goes up, the SLF shifts outwards to SLF2 and vice-versa.
The real rate of interest being the same, as wealth goes up, the SLF shifts outwards to SLF2 and vice-versa.
Here the real interest rate is determined in the open market at the intersection of the demand for loanable funds (DLF) and the supply of loanable funds (SLF), which is at point A.
At that point the equilibrium real interest rate is r*, and the demand for and supply of loanable funds is Q*.
Then as the demand for loanable funds or the supply of loanable funds change, r* changes.
This is identical to change in the price of any good (say coffee) in the marketplace.
The reason is that the real interest rate is the price paid for taking a loan, or the price received for sacrificing present consumption and supplying the loan.
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