276

MODULE 29

The Market for Loanable Funds

In this Module, you will learn to:

Recall that, for the economy as a whole, savings always equals investment spending. In a closed economy, savings is equal to national savings. In an open economy, savings is equal to national savings plus capital inflow. At any given time, however, savers, the people with funds to lend, are usually not the same as borrowers, the people who want to borrow to finance their investment spending. How are savers and borrowers brought together?

Savers and borrowers are matched up with one another in much the same way producers and consumers are matched up: through markets governed by supply and demand. In the circular-flow diagram, we noted that the financial markets channel the savings of households to businesses that want to borrow in order to purchase capital equipment. It’s now time to take a look at how those financial markets work.

The Equilibrium Interest Rate There are a large number of different financial markets in the financial system, such as the bond market and the stock market. However, economists often work with a simplified model in which they assume that there is just one market that brings together those who want to lend money (savers) and those who want to borrow money (firms with investment spending projects). This hypothetical market is known as the loanable funds market. The price that is determined in the loanable funds market is the interest rate, denoted by r. It is the return a lender receives for allowing borrowers the use of a dollar for one year, calculated as a percentage of the amount borrowed.

Recall that in the money market, the nominal interest rate is of central importance and always serves as the “price” measured on the vertical axis. The interest rate in the loanable funds market can be measured in either real or nominal terms—with or without the inclusion of expected inflation that makes nominal rates differ from real rates. Investors and savers care about the real interest rate, which tells them the price paid for the use of money aside from the amount paid to keep up with inflation. However, in the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal, so actual loan contracts specify a nominal interest rate rather than a real interest rate. For this reason, and because it facilitates comparisons between the money market and the loanable funds market, the figures in this section are drawn with the vertical axis measuring the nominal interest rate for a given expected future inflation rate. As long as the expected inflation rate is unchanged, changes in the nominal interest rate also lead to changes in the real interest rate. We take up the influence of inflation later in this module.

277

We should also note at this point that, in reality, there are many different kinds of nominal interest rates because there are many different kinds of loans—short-term loans, long-term loans, loans made to corporate borrowers, loans made to governments, and so on. In the interest of simplicity, we’ll ignore those differences and assume that there is only one type of loan. Figure 29.1 illustrates the hypothetical demand for loanable funds. On the horizontal axis we show the quantity of loanable funds demanded. On the vertical axis we show the interest rate, which is the “price” of borrowing. To see why the demand curve for loanable funds, D, slopes downward, imagine that there are many businesses, each of which has one potential investment project. How does a given business decide whether or not to borrow money to finance its project? The decision depends on the interest rate the business faces and the rate of return on its project—the profit earned on the project expressed as a percentage of its cost. This can be expressed in a formula as:

For example, a project that costs $300,000 and produces revenue of $315,000 provides a rate of return of [($315,000 – $300,000)/$300,000] × 100 = 5%.

A business will want a loan when the rate of return on its project is greater than or equal to the interest rate. So, for example, at an interest rate of 12%, only businesses with projects that yield a rate of return greater than or equal to 12% will want a loan. A business will not pay 12% interest to fund a project with a 5% rate of return. The demand curve in Figure 29.1 shows that if the interest rate is 12%, businesses will want to borrow $150 billion (point A); if the interest rate is only 4%, businesses will want to borrow a larger amount, $450 billion (point B). That’s a consequence of our assumption that the demand curve slopes downward: the lower the interest rate, the larger the total quantity of loanable funds demanded. Why do we make that assumption? Because, in reality, the number of potential investment projects that yield at least 4% is always greater than the number that yield at least 12%.

278

Figure 29.2 shows the hypothetical supply of loanable funds. Again, the interest rate plays the same role that the price plays in ordinary supply and demand analysis. Savers incur an opportunity cost when they lend to a business; the funds could instead be spent on consumption—say, a nice vacation. Whether a given individual becomes a lender by making funds available to borrowers depends on the interest rate received in return. By saving your money today and earning interest on it, you are rewarded with higher consumption in the future when your loan is repaid with interest. So it is a good assumption that more people are willing to forgo current consumption and make a loan when the interest rate is higher. As a result, our hypothetical supply curve of loanable funds slopes upward. In Figure 29.2, lenders will supply $150 billion to the loanable funds market at an interest rate of 4% (point X); if the interest rate rises to 12%, the quantity of loanable funds supplied will rise to $450 billion (point Y).

The equilibrium interest rate is the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. As you can see in Figure 29.3, the equilibrium interest rate, r_E, and the total quantity of lending, Q_E, are determined by the intersection of the supply and demand curves, at point E. Here, the equilibrium interest rate is 8%, at which $300 billion is lent and borrowed. Investment spending projects with a rate of return of 8% or more are funded; projects with a rate of return of less than 8% are not. Correspondingly, only lenders who are willing to accept an interest rate of 8% or less will have their offers to lend funds accepted.

Figure 29.3 shows how the market for loanable funds matches up desired savings with desired investment spending: in equilibrium, the quantity of funds that savers want to lend is equal to the quantity of funds that firms want to borrow. The figure also shows that this match-up is efficient in two senses. First, the right investments get made: the investment spending projects that are actually financed have higher rates of return than those that do not get financed. Second, the right people do the saving: the potential savers who actually lend funds are willing to lend for lower interest rates than those who do not. The insight that the loanable funds market leads to an efficient use of savings, although drawn from a highly simplified model, has important implications for real life. As we’ll see shortly, it is the reason that a well-functioning financial system increases an economy’s long-run economic growth rate.

279

Before we get to that, however, let’s look at how the market for loanable funds responds to shifts of demand and supply.

Shifts of the Demand for Loanable Funds The equilibrium interest rate changes when there are shifts of the demand curve for loanable funds, the supply curve for loanable funds, or both. Let’s start by looking at the causes and effects of changes in demand.

The factors that can cause the demand curve for loanable funds to shift include the following:

280

Figure 29.4 shows the effects of an increase in the demand for loanable funds. S is the supply of loanable funds, and D₁ is the initial demand curve. The initial equilibrium interest rate is r₁. An increase in the demand for loanable funds means that the quantity of funds demanded rises at any given interest rate, so the demand curve shifts rightward to D₂. As a result, the equilibrium interest rate rises to r₂.

The fact that, other things equal, an increase in the demand for loanable funds leads to a rise in the interest rate has one especially important implication: beyond concern about repayment, there are other reasons to be wary of government budget deficits. As we’ve already seen, an increase in the government’s deficit shifts the demand curve for loanable funds to the right, which leads to a higher interest rate. If the interest rate rises, businesses will cut back on their investment spending. So a rise in the government budget deficit tends to reduce overall investment spending. Economists call the negative effect of government budget deficits on investment spending crowding out. The threat of crowding out is a key source of concern about persistent budget deficits.

Shifts of the Supply of Loanable Funds Like the demand for loanable funds, the supply of loanable funds can shift. Among the factors that can cause the supply of loanable funds to shift are the following:

281

Figure 29.5 shows the effects of an increase in the supply of loanable funds. D is the demand for loanable funds, and S₁ is the initial supply curve. The initial equilibrium interest rate is r₁. An increase in the supply of loanable funds means that the quantity of funds supplied rises at any given interest rate, so the supply curve shifts rightward to S₂. As a result, the equilibrium interest rate falls to r₂.

Inflation and Interest Rates Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate. Historically, major changes in interest rates have been driven by many factors, including changes in government policy and technological innovations that created new investment opportunities. However, arguably the most important factor affecting interest rates over time—the reason, for example, why interest rates today are much lower than they were in the late 1970s and early 1980s—is changing expectations about future inflation, which shift both the supply of and the demand for loanable funds.

To understand the effect of expected inflation on interest rates, recall our discussion in Module 14 of the way inflation creates winners and losers—for example, the way that high U.S. inflation in the 1970s and 1980s reduced the real value of homeowners’ mortgages, which was good for the homeowners but bad for the banks. We know that economists capture the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the distinction is as follows:

Real interest rate = Nominal interest rate – Inflation rate

The true cost of borrowing is the real interest rate, not the nominal interest rate. To see why, suppose a firm borrows $10,000 for one year at a 10% nominal interest rate. At the end of the year, it must repay $11,000—the amount borrowed plus the interest. But suppose that over the course of the year the average level of prices increases by 10%, so that the real interest rate is zero. Then the $11,000 repayment has the same purchasing power as the original $10,000 loan. In effect, the borrower has received a zero-interest loan.

Similarly, the true payoff to lending is the real interest rate, not the nominal rate. The bank that makes the one-year $10,000 loan at a 10% nominal interest rate receives an $11,000 repayment at the end of the year. But the 10% increase in the average level of prices means that the purchasing power of the money the bank gets back is no more than that of the money it lent out. In effect, the bank has made a zero-interest loan.

282

The expectations of borrowers and lenders about future inflation rates are normally based on recent experience. In the late 1970s, after a decade of high inflation, borrowers and lenders expected future inflation to be high. By the late 1990s, after a decade of fairly low inflation, borrowers and lenders expected future inflation to be low. And these changing expectations about future inflation had a strong effect on the nominal interest rate, largely explaining why interest rates were much lower in the early years of the twenty-first century than they were in the early 1980s.

Let’s look at how changes in the expected future rate of inflation are reflected in the loanable funds model. In Figure 29.6, the curves S₀ and D₀ show the supply of and demand for loanable funds given that the expected future rate of inflation is 0%. In that case, equilibrium is at E₀ and the equilibrium nominal interest rate is 4%. Because expected future inflation is 0%, the equilibrium expected real interest rate over the life of the loan, the real interest rate expected by borrowers and lenders when the loan is contracted, is also 4%.

Now suppose that the expected future inflation rate rises to 10%. The demand curve for funds shifts upward to D₁₀: borrowers are now willing to borrow as much at a nominal interest rate of 14% as they were previously willing to borrow at 4%. That’s because with a 10% inflation rate, a borrower who pays a 14% nominal interest rate pays a 4% real interest rate. Similarly, the supply curve of funds shifts upward to S₁₀: lenders require a nominal interest rate of 14% to persuade them to lend as much as they would previously have lent at 4%. That’s because with a 10% inflation rate, a lender who receives a 14% nominal interest rate receives a 4% real interest rate. The new equilibrium is at E₁₀: the result of an increase in the expected future inflation rate from 0% to 10% is that the equilibrium nominal interest rate rises from 4% to 14%.

This situation can be summarized as a general principle, named the Fisher effect after the American economist Irving Fisher, who proposed it in 1930: an increase in expected inflation drives up the nominal interest rate by the same number of percentage points, leaving the expected real interest rate unchanged. The central point is that both lenders and borrowers base their decisions on the expected real interest rate. As a result, a change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.