Lesson summary: the market for loanable funds (article)

Lesson summary

Investment spending is an important category of real GDP. Not only is it usually the most volatile part of real GDP, but investment spending on physical capital is also an important contributor to economic growth. So, if a firm wants to build a new factory, where does it get the funds to build it? Usually, firms borrow that money.

The market for loanable funds describes how that borrowing happens. The supply of loanable funds is based on savings. The demand for loanable funds is based on borrowing. The interaction between the supply of savings and the demand for loans determines the real interest rate and how much is loaned out.

Key Terms

Key term	Definition
the market for loanable funds	a hypothetical market that shows how loans from savers are allocated to borrowers who have investment projects
savings-investment spending identity	an equation that demonstrates that investment spending and savings are always equal to each other; if there is $$ 100,000$ ‍ in investment in an economy, that $$ 100,000$ ‍ has to come out of savings.
budget surplus	when taxes collected are more than the amount of government spending, the difference between taxes and government spending is a budget surplus
budget deficit	when taxes collected are less than the amount of government spending, the difference between taxes and government spending is a budget deficit
budget balance	when the amount of taxes collected is exactly equal to the amount of government spending
public saving	the difference between taxes collected and government spending; when there is a budget surplus public saving is positive, but when there is a budget deficit public saving is negative.
disposable income	income that is left for consumption after taxes are paid; if your income is $$ 100$ ‍ and you pay $$ 5$ ‍ in taxes, your disposable income is $$ 95$ ‍.
private saving	what is left of disposable income after consumption is taken out; if your disposable income is $$ 95$ ‍ and you spend $$ 70$ ‍, you have $$ 25$ ‍ left in savings.
national savings	the total amount of private saving and public saving
closed economy	an economy which does not allow international trade or the movement of financial assets into or out of a country
open economy	an economy which does allow international trade or the movement of financial assets into or out of a country
foreign funds	financial assets, such as money, that come into a country from another country; if a resident of Florin buys a bond from the government of Guilder, that purchase represents foreign funds coming into Guilder.
domestic outflow of funds	financial assets that leave a country; If a resident of Florin buys a bond from the government of Guilder, that purchase represents domestic funds flowing out of Florin.
capital inflows	financial capital coming into a country; capital inflows are equal to the inflow of foreign funds minus the outflow of domestic funds.
rate of return	percentage gain or loss on an investment or the increase or decrease in value over time; for example, if a project costs $$ 100$ ‍ to do but will generate $$ 108$ ‍ in sales, its rate of return is 8%.
demand for loanable funds	a hypothetical curve that shows the willingness to borrow money to fund investment projects; as the interest rate decreases, the quantity of loans demanded will increase.
supply of loanable funds	a hypothetical curve that shows the willingness to save money and put it into a financial intermediary.

Key Takeaways

National savings

In a closed economy, national savings is the sum of private saving and the public saving. In an open economy, national saving is the sum of private savings, the public saving, and net capital inflows.

For example, suppose the nation of Florin has:

a national income of $$ 100$ ‍ million,
taxes of $$ 10$ ‍ million,
consumption spending of $$ 60$ ‍ million
government spending of $$ 8$ ‍ million,
and net capital inflows of $$ 4$ ‍ million.

The national savings that they have available is therefore:

$\begin{aligned} National savings & = P r i v a t e s a v i n g s + P u b l i c s a v i n g s + N C I \\ = ($ 100 million income - $ 10 million taxes - $ 60 million consumption) + ($ 10 million taxes - $ 8 million government spending) + $ 4 million NCI \\ = $ 30 million + $ 2 million + $ 4 million \\ = $ 36 million \end{aligned}$ ‍

National savings would be $$ 36$ ‍ million in Florin. That means there is $$ 36$ ‍ million in savings that could be turned into loans that could fund investment spending.

The loanable funds market describes the behavior of savers and borrowers.

The market for loanable funds is a way of representing all of the potential savers and all of the potential borrowers in an economy. It has the same features of other markets that we have seen before, but with a few twists:

Quantity - loans are being “bought” and “sold” in this market. The “quantity” in this market is really the quantity of loans or, more formally, the quantity of loanable funds. Why? It’s not how many loans are being made, but how much loaning is going on.
Price - the cost of borrowing is the real interest rate, and the reward for savings is the real interest rate. Therefore, we use the real interest rate (rather than price) in the market for loanable funds.
Supply - The supply of loanable funds represents the behavior of all of the savers in an economy. The higher interest rate that a saver can earn, the more likely they are to save money. As such, the supply of loanable funds shows that the quantity of savings available will increase as the interest rate increases.
Demand - The demand for loanable funds represents the behavior of borrowers and the quantity of loans demanded. The lower the interest rate, the less expensive it is to borrow.

Equilibrium - The equilibrium in the market for loanable funds is achieved when the quantities of loans that borrowers want are the same as the quantity of savings that savers provide. The interest rate adjusts to make these equal.

Sure! Suppose there are some people in Florin who each have $$ 1000$ ‍ that they are considering spending or saving. Each of them has different preferences for consumption and saving, which impacts their willingness to save. For example, Westley is very patient and willing to save money even at low-interest rates. But Humperdink would much rather spend money, so it takes a pretty high-interest rate to convince him to save:

Person	minimum interest rate needed to save $$ 1000$ ‍	Total savings available at this interest rate
Westley	1%	$$ 1000$ ‍
Buttercup	2%	$$ 2000$ ‍
Inigo	3%	$$ 3000$ ‍
Fizzig	4%	$$ 4000$ ‍
Yellin	5%	$$ 5000$ ‍
Bella	6%	$$ 6000$ ‍
Valerie	7%	$$ 1000$ ‍
Humperdink	8%	$$ 8000$ ‍

At the same time, a few of the businesses in Florin have some capital projects they would like to complete. The table below summarizes them:

Firm	Capital Project and cost	Projected return
Miracle Max’s Magic Academy	new lecturing equipment - $$ 1300$ ‍	2%
Dread Pirate Roberts’ School of Sailing	new sail $$ 1600$ ‍	3%
Count Rugen’s Rack’o’Ribs	new grill $$ 1900$ ‍	4%
Vizzini Pharma	develop iocaine antidote $$ 2000$ ‍	5%
Yeste’s Sword o'Rama	new foundry $$ 3000$ ‍	6%

Real interest rate	QD LF	QS LF
1%	$$ 1300$ ‍ + $$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 10, 000$ ‍	$$ 1000$ ‍
2%	$$ 1300$ ‍ + $$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 10, 000$ ‍	$$ 2000$ ‍
3%	$$ 1600$ ‍ + $$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 8, 700$ ‍	$$ 3000$ ‍
4%	$$ 2100$ ‍ + $$ 2000$ ‍ + $$ 3000$ ‍ = $$ 7100$ ‍	$$ 4000$ ‍
5%	$$ 2000$ ‍ + $$ 3000$ ‍ = $$ 5, 000$ ‍	$$ 5000$ ‍
6%	$$ 3, 000$ ‍	$$ 6, 000$ ‍

Changes in the demand for loanable funds

Anything that changes investment demand will change the demand for loanable funds. Examples of events that can shift the demand for loanable funds are

Changes in the anticipated rate of return earned on investment spending
Government policies

There is an important implication of that first determinant of investment demand: real interest rates are procyclical. When the economy is doing well, the rate of return on any investment spending will increase. That means the demand for loanable funds will increase, which leads to a higher real interest rate. In other words, we would expect to see an increase in real interest rates, and the quantity of loans made, when the economy is doing well.

Some government policies, such as investment tax credits, basically lower the cost of borrowing money at every real interest rate. Such policies would increase the demand for loanable funds. Other policies, such as budget deficits, might increase the demand for loanable funds.

Changes in the supply of loanable funds changes

Anything that impacts savings behavior impacts the supply of loanable funds. Some examples of that are:

Changes in saving behavior, such as preferences for saving or having more wealth
Changes in capital inflows
Changes in public savings

Do deficits cause a shift in supply or demand?

That’s an interesting question! There are actually two points of view:

Deficits increase the demand for loanable funds; surpluses decrease the demand for loanable funds. The logic of this point of view is that if the government runs a deficit, it has to borrow money just like everyone else. So, if there is a deficit, the demand for loanable funds will increase because the government gets in line to borrow money just like all of the other borrowers.
Deficits decrease the supply of loanable funds; surpluses increase the supply of loanable funds. The logic of this point of view is that national savings includes public savings (T-G), and national savings is the source of the supply of loanable funds. So anything that makes T-G smaller (like a deficit) or bigger (like a surplus) will shift the supply of loanable funds

But that doesn’t mean both curves shift? Supply and demand do not have the same determinants in any market. Your graphical model should reflect only one point of view.

In the end, both points of view have the same impact on the real interest rate: deficits increase the real interest rate and surpluses decrease the real interest rate.

The Fisher Effect

The Fisher effect states that an increase in expected future inflation will increase nominal interest rates by exactly the amount of expected inflation. Expected inflation will have no impact on either the quantity of loanable funds or the real interest rate.

For example, suppose the current rate of inflation is 2% and the real interest rate is 5%. Then the current nominal interest rate is 7%:

$\begin{aligned} Nominal interest rate & = real interest rate + inflation \\ = 5 % + 2 % \\ = 7 % \end{aligned}$ ‍

If people expect inflation to decrease by 1%, then both savers and borrowers will take this into account, and they will incorporate this into their expected rate of inflation:

$\begin{aligned} Nominal interest rate & = real interest rate + inflation \\ = 5 % + (- 1) % \\ = 4 % \end{aligned}$ ‍

Key graphical models

The market for loanable funds

The market for loanable funds shows the supply of savings and the demand for loans. The real interest rate adjusts until the quantity of savings supplied is equal to the quantity of loans demanded.

Key equations

The savings and investment identity

$S = I$ ‍

The savings and investment identity states that all investment spending must be is done from savings.

This identity doesn’t appear out of thin air, it comes from national income. Let’s start with the fact that national income (Y) is equal to aggregate expenditures:

$Y = C + I + G + N X$ ‍

To make things simpler, let’s assume that the economy is a closed economy. That means that there is no international trade and there is no movement of financial assets into or out of a country. So, the NX disappears from our national income:

$Y = C + I + G$ ‍

Notice the “ $I$ ‍”? That is investment spending from our savings and investment identity! So, let’s isolate “ $I$ ‍” so it is on its own in the equation:

$Y - C - G = I$ ‍

Before we can break this down further, we need to recognize that government spending is paid using taxes. Taxes are taken out of income, and then government spending is taken out of taxes, as shown in the equation below:

$Y - T - C + T - G = I$ ‍

We are left with two components of national saving: private saving (Y-T-C) and public saving (T-G).

Ok, so what if this is an open economy, not a closed economy? In that case, we have to allow for the possibility that some of these savings on the left-hand side of the equation will go overseas, or that some savings will come overseas into this economy. So, we also need to include net capital inflows ( $N C I$ ‍):

$Y - T - C + T - G + N C I = I$ ‍

The left-hand side of the equation shows the total amount of savings available. We can break it down into three components:

Component	Source of funds
$Y - T - C$ ‍	Private savings: The amount leftover after consumption is deducted from disposable income
$T - G$ ‍	Public savings: The amount of budget surplus or budget deficit
$N C I$ ‍	Net capital inflows: the difference between financial capital entering the country and financial capital leaving the country.

Common misperceptions

It might seem strange that we are using the word “investment” to talk about borrowing money when people usually use the word “investment” as a place to put their savings. Remember that in economics the word “investment” refers to spending by businesses on physical capital, inventories, and other business expenditures. That business capital will require borrowing, so investment requires loans.
The Fisher effect describes a change in nominal interest rates, not real interest rates. Expected inflation will be incorporated into the nominal interest rates, but the real interest rate is not impacted by inflation.

Review Questions

In a correctly labeled graph of the loanable funds market, show the impact of an increase in national savings on the interest rate.
The economy of Florin has a balanced budget. They then experience the negative demand shock shown here:

If there are automatic stabilizers, will the budget move into a deficit, surplus, or budget balance? Explain
Show the impact on the interest rate of the change you indicated in part (a) on a correctly labeled graph of the market for loanable funds.

The budget will move to a deficit. The graph shown indicates that the economy moved into a recession. When there are automatic stabilizers, a recession will cause taxes to decrease and government spending to increase. This will cause a deficit.
There are two possible correct answers, but both should show an increase in the interest rate.

Lesson summary: the market for loanable funds (article) | Khan Academy (2024)