Basics of Loanable Funds Theory - Interest Rate Determination

Loanable funds are the money available in an economy for lending and borrowing. They come from sources like household savings, business profits, government surpluses, and foreign investments. The theory of loanable funds explains how the interaction of supply (savers) and demand (borrowers) in financial markets determines interest rates, which are the "price" of borrowing funds.

The Loanable Funds Theory explains how interest rates are determined by the interaction of supply and demand for loanable funds in financial markets. This theory highlights the dynamics of savings and investments and their influence on borrowing costs.

Key Concepts

1. Supply of Loanable Funds:
   • Primarily derived from household savings, but also includes funds from government surpluses, foreign capital inflows, and retained business profits.
   • Savings behavior is influenced by the real interest rate; higher rates encourage more saving.
2. Demand for Loanable Funds:
   • Driven by borrowers such as businesses (for investments), governments (fiscal deficits), and households (consumption and mortgages).
   • Inversely related to the interest rate; higher rates reduce borrowing.
3. Equilibrium Interest Rate:
   • Occurs when the supply of loanable funds equals demand, ensuring all available savings are used efficiently.

Key Insights and Implications

1. Interest Elasticity of Demand:
   • Borrowing can be interest-inelastic for essential needs or government deficits, meaning borrowing continues even at higher interest rates.
2. Higher Savings Impact:
   • Increased savings raise the supply of loanable funds, lowering interest rates (ceteris paribus).
3. Fiscal Deficits Impact:
   • Large fiscal deficits increase demand for funds, potentially driving up interest rates and crowding out private investment.
4. Global Challenges:
   • Cross-border financial flows and exchange rate considerations complicate the application of the theory in a globalized world. Factors like currency risks and international capital mobility influence interest rate dynamics.