Loanable Funds

Loanable Funds

• Supply of Loanable Funds are the national savings. As the interest rate rises, we earn

  more

  ---

  on our savings so we have an incentive to save

  more

  ---

  . This is why the supply is upward sloping.
• Demand for Loanable Funds is the Investment because it comes from firms borrowing money to buy capital goods (machines) and families taking mortgages to buy houses. Either way this is considered investment expenditure. As the interest rate falls, it is

  cheaper

  ---

  for firms to borrow money, which is why the demand is downward sloping.
• If the interest rate is below equilibrium there is an excess

  demand

  ---

  or shortage of loanable funds and when interest rate is above equilibrium there is an excess

  supply

  ---

  or surplus of loanable funds.

Factors That Affect Supply

• Government budget surpluses / deficits - There can be crowding out caused by government deficits which leads to supply of loanable funds shifting to the

  left

  ---

  causing interest rates to

  rise

  ---

  and Investment to

  decrease.

  ---

• Tax incentives for saving more - If there are more incentives like a tax-free savings account then national savings will

  increase

  ---

  meaning shift to the

  right

  ---

  which would cause equilibrium interest rate to

  decrease

  ---

Factors That Affect Demand

• Tax credit for Investment - If the government gives a tax break for firms spending more on Investment expenditure, the demand for loans will

  increase

  ---

  meaning shift to the

  right

  ---

  and this will cause equilibrium interest rate to

  increase

  ---

• Vicious circle - the cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment, and result in slower economic growth; slower growth leads to lower tax revenue and higher spending on income- support programs, and the result can be even higher budget deficits

• Virtuous circle - the cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment, and result in faster economic growth; faster growth leads to higher tax revenue and lower spending on income- support programs, and the result can be even higher budget surpluses

• Government Net Debt - the difference between the value of government financial liabilities and financial assets. The government can borrow from other countries, the central bank, the World Bank and commercial banks.

Example: Loanable Funds