SUPPLY AND DEMAND FOR LOAN ABLE FUNDS
The economy’s market for loan able funds, like other markets in the economy, is governed by supply and demand. To understand how the market for loan able funds operates, therefore, we first look at the sources of supply and demand in that market The supply of loan able funds comes from people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which in turn uses the funds to make loans. In both cases, saving is the source of the supply of loan able funds.
The demand for loan able funds comes from households and firms who wish to borrow to make investments. This demand includes families taking out mortgages to buy new homes. It also includes firms borrowing to buy new equipment or build factories. In both cases, investment is the source of the demand for loan able founds. The interest rate is the price of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. Because a high interest rate makes borrowing more expensive, the quantity of loan able funds demanded falls as the interest rate rises. Similarly, because a high interest rate makes saving more attractive, the quantity of loan able funds supplied rises as the interest rate rises. In other words, the demand curve for loan able funds slopes downward, and the supply curve for loan able funds slopes upward.
Figure 1 The Market for Loan able Funds
The interest rate in the economy adjusts to balance the supply and demand for loan able funds. The supply of loan able funds comes from national saving, including both private saving and public saving. The demand for loan able funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent, and S l,200 billion of loan able funds are supplied and demanded.
The adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loan able funds supplied-would be less than the quantity of loan able funds demanded. The resulting shortage of loan able funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loan able funds supplied) and discourage borrowing for investment (thereby decreasing the quantity of loan able funds demanded). Conversely, if the interest rate were higher than the equilibrium level, the quantity of loan able funds supplied would exceed the quantity of loan able funds demanded. As lenders competed for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply and demand for loan able funds exactly balance Recall that economists distinguish between the real interest rate and the nominal interest rate. The nominal interest rate is the interest rate as usually reported-the monetary return to saving and the monetary cost of borrowing. The real interest rate is the nominal interest rate corrected for inflation it equals the nominal interest rate minus the inflation rate. Because inflation erodes the value of motley over time, the real interest rate before accurately reflects the real return to saving and the real cost of borrowing There fore, the supply and demand for loan able funds depend on the real (rather than nominal) interest rate, and the equilibrium in Figure 1 should be interpreted as determining the real interest rate in the economy For the rest of this chapter, when you see the term interest rate, you should remember that we are talking about the real interest rate This model of the supply and demand for loan able funds shows that financial markets work much like other markets in the economy. In the market for milk, for instance, the price of milk adjusts so that the quantity of milk supplied balances the quantity of milk demanded. In this way, the invisible hand coordinates the behavior of dairy farmers and the behavior of milk drinkers. Once we realize that saving represents the supply of loan able funds and investment represents the demand, we can see how the invisible hand coordinates saving and investment. When the interest rate adjusts to balance supply and demand in the market for loan able funds, it coordinates the behavior of people who want to save (the suppliers of loan able funds) and the behavior of people who want to invest (the demanders of loan able We can now use this analysis of the market for loan able funds to examine various government policies that affect the economy’s saving and investment. Because this model is just supply and demand in a particular market, we analyze any policy using the three steps discussed in Chapter 4. First, we decide whether the policy shifts the supply curve or the demand curve. Second, we determine the direction of the shift. Third, we use the supply-and-demand diagram to see how the equilibrium changes.
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