What They Are, How They Work

What Are Loanable Funds?

Loanable funds are a big part of how money moves through our economy, representing the availability of capital for investment. Loanable funds include all forms of credit, such as loans (personal, business, etc.) and savings deposits. They are made available for capital investment and represent the amount of money available for others to borrow.

How Loanable Funds Work

The market for loanable funds isn’t a “real” market like you see with a stock exchange. Instead, it’s largely hypothetical. The market for loanable funds is a way to illustrate where money is coming from and who wants to use it for various projects. It’s a way to express how borrowers and lenders connect in our economy.

Supply of Loanable Funds

The supply of loanable funds come primarily from savings by households and businesses. For example, let’s say you make $4,000 this month. After taxes are taken from your paycheck and you pay all your bills, let’s say you have $500 left.

You put that $500 in a bank account, and the bank is able to, in turn, lend it out to someone else. You earn a yield on the amount you have in savings, and the bank can put those funds to work in the economy by lending it to someone else who. This keeps the supply moving through our economic system.

Demand for Loanable Funds

Demand for loanable funds comes from those who want to finance capital expenditures or purchases, but they don’t have the amount needed or don’t want to dip into their own savings.

For example, if a business wants to expand its manufacturing capabilities, it might borrow the money needed to make the necessary capital investment. With this funding, the business is able to purchase additional machinery and/or real estate. As a result, it’s in a better position to make more sales and hire more workers, thus growing the economy.

Individual loans represent another way loanable funds can be in demand. Let’s say you want to make a large purchase, such as a car, but you don’t have a sufficient savings. You can instead finance this purchase by getting an auto loan from a bank, which would lend you some of the money it has from savings deposits. The amount you borrow allows you to make and unaffordable purchase, while keeping the funds moving through the economy.

How the Loanable Funds Market Maintains Equilibrium

When using the loanable funds framework, interest rates adjust so supply and demand are in equilibrium. The idea is to reach a point where the amount of money being lent out equals the availability of loanable funds. Interest rates are meant to help achieve this equilibrium.

For example, if interest rates are too high, there’s too much supply. With high rates, people are more likely to keep their money in savings accounts and limit their spending. This means that additional money is available for businesses to borrow. However, the downside to this situation is that they’ll typically face higher interest rates on any loans they try to take out. As a result, they might be less willing to borrow and instead rely on their own saved capital.

On the other hand, loan demand increases if interest rates are too low, as more individuals and businesses want to take advantage of “other people’s money” to make their purchases and investments. At the same time, the yields on savings accounts are low enough that consumers are discouraged from keeping their money in the bank.

Factors Influencing the Loanable Funds Market

The loanable funds market is far from as simple as presented by its theoretical framework. There’s a lot going on that can impact how people and businesses feel about saving, spending, and borrowing.

Interest Rates

As previously mentioned, interest rates can have a big impact on behavior in the loanable funds market. When interest rates are too high, borrowing is less popular, even if a large amount of loanable funds is available in bank deposit accounts.

Economic Conditions

Inflation impacts interest rates and how people behave. For example, high inflation reduces the value of the yield you receive for keeping your money in a savings account. If the account has a 4% annual percentage yield (APY), but inflation is 5%, that money is losing value by sitting in the bank.

To slow inflation, policymakers can increase benchmark rates, which can attract savers, but it also makes borrowing more expensive. Meanwhile, people are less likely to spend during a recession, so savings can grow, increasing the supply of loanable funds.

Government Policies

Tax incentives resulting from government policy can also impact the loanable funds market. Tax credits to businesses often increase the desire for capital expenditures, raising the demand for loanable funds. However, if the government prioritizes incentives for savers, it could lead to a higher supply of loanable funds.

The Bottom Line

The loanable funds market keeps money moving through our economy. In our current economic system, the movement of capital creates wealth or at least encourages a higher gross domestic product (GDP). The availability of capital access for continued consumer purchasing and business investment is a main driver of economic activity.