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- How does the loanable funds market work
What’s it: Loanable funds market is a market where the demand and supply of loanable funds interact in an economy. This term, you will probably often find in macroeconomics books.
Basically, this market is a domestic financial market. Transactions involve money, not goods or services.
The loanable funds’ supply comes from households, businesses, or the government. Households keep a portion of their income for savings. Likewise, the company allocates a portion of its profit (cash) to various financial instruments. Meanwhile, the government supplies money if it runs a fiscal surplus where tax revenue exceeds expenditure.
Meanwhile, the loanable funds demand also comes from those three sectors. Households borrow funds (for example, from banks) to buy various items such as houses and cars. Companies use it for capital expenditures. Meanwhile, the government uses funds to cover the budget deficit.
In discussing this topic, you will find various terms of money, such as cash, funds, or capital.
The cost of borrowing money is interest (except for equity). It can take various names, such as coupons or bank interest.
As in the goods market, in the loanable funds market, the interest rate represents a price, which can mean the return or cost of borrowing money. For the supplier of funds, it is a return. Meanwhile, for borrowers, it is the cost of borrowing money.
How does the loanable funds market work
In general, knowledge of the supply-demand concept is useful for you to understand how the loanable fund market works.
Supply represents total loanable funds available at a certain interest rate. It is the amount of national savings in a country. Meanwhile, demand represents the total funds available to be borrowed at a certain interest rate.
The loanable funds market reaches equilibrium when demand equals supply, determining the amount of loanable funds and the economy’s interest rate.
Loanable funds supply
The supply of loanable funds comes from the household (individual), business, or government sector.
When individuals save part of their income, the savings are available for other parties to borrow. If you are saving in a bank deposit account, the money you are saving is part of the loanable funds supply. As a financial intermediary, the bank then lends it to another party, whether it is an individual or a business.
For instance, suppose you have an income of IDR20 million and spend IDR17 million on the consumption of goods and services. You save the rest (IDR 3 million). This Rp3 million nominal is now available for other parties to borrow.
The supply of loanable funds increases with the increase in interest rates. As I said earlier, the interest rate represents the return you get when you lend money. If interest rates go up, you get a higher return.
Not only you, but other individuals or businesses will also do the same when interest rates rise. As a result, the loanable funds supply in the economy increases. This is why the loanable fund’s supply curve has a positive slope – showing a positive relationship between the loanable funds’ supply and the interest rate.
Loanable fund suppliers can take various terms such as savers, investors, shareholders, or bondholders.
Loanable funds demand
The demand for loanable funds represents the desire to borrow money at a certain interest rate. Demand comes from the household, business, and government sectors. And, it can take a variety of ways such as borrowing from the bank, issuing bonds, or issuing stocks.
The demand for loan funds is to meet various purposes. Businesses need funds to build factories or buy new machines. Households need it to buy a house or car. The government needs funds to finance the budget deficit.
Especially for the government, demand is zero when running a budget surplus. Because revenue exceeds expenditure, the government, in this case, acts as a supplier. In macroeconomics, we refer to the amount of loanable funds supplied by the government as public savings.
The loanable funds’ demand is determined by the interest rate. The two have an inverse relationship. If we plot it on a graph, the demand curve for loanable funds has a downward slope (negative).
For the borrower, the interest rate represents the cost of borrowing funds. The higher the interest rate, the greater the cost of paying it back. So, when interest rates rise, the demand for loanable funds decreases.
Equilibrium in the loanable fund market
An equilibrium in the loanable fund market occurs when demand equals supply for loanable funds. In a graph, equilibrium takes place at the point where the demand and supply curves intersect. At this point, the equilibrium interest rate in the economy is determined.
What happens when the loanable fund market is in disequilibrium.
Two conditions of equilibrium:
- Excess supply
- Excess demand
Suppose the market interest rate is higher than the equilibrium interest rate. In that case, the market faces an excess supply of loanable funds. As a result, interest rates have a tendency to fall.
Because interest rates are higher, borrowing costs are more expensive. This causes the demand for loanable funds to decrease. As a result, interest rates will be encouraged to fall.
If the market rate is below the equilibrium interest rate, the market faces excess demand. The loanable funds’ demand is higher than the supply. Low-interest rates make suppliers of funds reluctant to save.
On the other hand, low-interest rates tend to attract large numbers of borrowers. This is because the borrowing cost is cheaper. This situation provides an incentive for borrowers to demand more funds.
The excess demand will eventually push the interest rate up toward a new equilibrium. Interest rates will continue to increase until the supply of funds equals the demand for funds.
A shift in the curve in the loan-fund market
Movements along the demand and supply curves occur because of changes in interest rates.
Meanwhile, both curves will shift only if the non-interest rate factor changes.
Meanwhile, two factors that cause the demand for loanable funds to shift are:
- Change in opportunities perceived by businesses
- Changes in government spending
Say, the government increases the budget deficit. The increase in deficit prompted the government to increase the demand for loanable funds on the financial market. It leads the demand curve to shift to the right and causes the economy’s interest rates to rise.
Furthermore, two factors that cause a shift in the supply curve are:
- Changes in saving behavior by the private sector
- Changes in capital inflows
Say, households are becoming increasingly aware of the importance of saving. Now, they allocate more of each additional income to savings. Such changes in saving behavior will increase the supply of funds in the domestic market. Specifically, we call the saving portion of each additional income the marginal propensity to save (MPC).
Meanwhile, foreign investment inflows increased the supply of loanable funds in the country. That leads the supply curve to shift to the right. Conversely, capital outflows will cause the curve to shift to the left and borrowed funds to decrease.
Crowding out effect
The government budget deficit increases demand on the domestic loanable fund market. That will encourage domestic interest rates to rise.
As interest rates rise, borrowing costs are more expensive. When investing in capital goods, businesses often borrow because of limited internal funding capacity. Thus, an increase in interest rates makes investment costs more expensive. That forces them to delay investing. The negative effect of a government budget deficit on investment spending is called crowding out.
The deficit increases because the government may increase spending to spur economic growth. But, at the same time, it keeps private investment down. The net effect on economic growth depends on, which is more significant, government spending or private investment.
One option to reduce the crowding-out effect is to borrow from the international market. Say, the government finances the increase in the deficit by borrowing from abroad (for example, by issuing global bonds). It doesn’t result in an increase in demand for loanable funds in the domestic market. Hence, domestic interest rates should not increase.