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Loanable funds market

Loanable funds are the supply and demand of funds that can be lent out to borrowers. Key players in this market include savers (the suppliers) and borrowers (the demanders). Learn about the role that the real interest rate plays, and how shifts in the supply or demand for loanable funds can impact real interest rate and quantity of funds available.

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Video transcript

- [Instructor] We are used to thinking about markets for goods and services, and demand and supply of goods and services, and what we're gonna do in this video is broaden our sense of what a market could be for by thinking about the market for loanable funds. Now, this might seem like a very technical term, loanable funds, but it literally just means funds that people are supplying to be lent out to other people and funds that people are demanding that they want to borrow. And so, one way to think about this market, the suppliers in the loanable funds market, these are the savers. So, when you go and save some money, maybe at a bank, that bank will then lend that money to someone else and because the bank is getting interest from that person, they can also afford to pay you some interest, so you get a return. It doesn't always have to be through a bank, but that tends to be typical. It will go through some type of intermediary. Similarly, who are the demanders or where's the demand coming from? I don't know if demanders is a real word, but I'll just write it down. So, where is the demand coming from? Well, that is coming from the borrowers who are interested in, maybe, making an investment, maybe some type of business opportunity is available to them. And as I mentioned, this isn't a market where the suppliers and the demanders, or the savers and the borrowers, necessarily directly interact with each other. Every now and then you might get a loan from your sister-in-law or from your parents, but oftentimes, usually, it's going through some type of institution, some type of financial institution, usually banks, where the savers put their money in a bank hoping, not just for save keeping, but really to get a return on their money. In order to provide a return to those savers, the bank will then lend it out to borrowers and charge interest to them. And to appreciate this in the way that we've looked at markets before, I can set up two axes and in any market that we've looked at before, the horizontal axis, this is the quantity, and so here, we're talking about the quantity of loanable funds, loanable funds. And then on the vertical axis, we normally think about the price for the good or service, but when we're dealing with loanable funds, the price is the interest rate. And if we want to know the real price, we should be talking about the real interest rate. Real interest rate. And so, let's think about each of these scenarios. Let's think about the savers who are really the suppliers in the loanable funds market. When real interest rates are lower, if real interest rates are low, they don't wanna really supply a lot of quantity. They're not getting, not a lot of motivation to be a supplier, to save in that situation. But if real interest rates are high, well, then they might say, I'm more likely to save and I wanna make my funds available for loaning out to other people 'cause I get this great interest rate, especially when it's a real interest rate. So, we could view it as something like this. This we could call our supply of loanable funds and you could imagine what the demand curve for loanable funds looks like. When real interest rates are high, people say, hey, you know, there aren't that many business opportunities that could justify borrowing at that high of a rate, so there wouldn't be much quantity that is demanded. But as the real interest rates, or if the real interest rates are lower, as they get lower, then the quantity demanded of loanable funds will be higher. So, this is our demand for loanable funds and like we've seen in the past, you're going to have an equilibrium quantity and price, where price, in this situation, is your real interest rate and so that's going to happen where these intersect. This is our equilibrium quantity and this is our equilibrium real interest rate. Now, let's think about what would happen if one or both of these curves were to shift somehow. And there's a couple of ways, let's start with the demand for loanable funds. There's a couple of ways that the demand for loanable funds curve could shift. Maybe all of a sudden people see new business opportunities. Astroid mining is becoming a thing and so people wanna borrow money to get robots and send them out into space so they can mine asteroids for platinum or something. Well, what would happen? Pause this video and think about that. Well, then at any given real interest rate, there's gonna be a higher quantity demanded. So, in that situation, our demand for loanable funds would shift to the right. It would look something like this. So, this is demand for loanable funds, I'll call it sub two. Sometimes you'll see something like a prime there, but I'll call it sub two. So, it has shifted to the right because of new business opportunities. Another common reason why that might shift to the right is if maybe the government is doing a lot more borrowing. Remember, this is an aggregate market here. So, the government, when it borrows money to fuel its spending, that also, it has to go into the loanable funds market and so, increased government borrowing would also shift this to the right. And if the opposite happened, if people thought there were fewer business opportunities or if the government started to borrow less, well, that would shift things to the left. But let's just think about what would happen. If R is the current equilibrium interest rate, if that just stayed where it is, well, then you're going to have a shortage of loanable funds, where the suppliers would be willing to supply this quantity while the borrowers are going to want this quantity here at that real interest rate. And so what you're going to have happen is you're gonna get to a new equilibrium point. The real interest rate is going to go up to this point, let's call that our new equilibrium real interest rate, and our quantity is going to go up as well, so Q1. In order to convince more suppliers to part with their money, not part with their money, or at least make their money available for lending, well, the interest rate's going to have to go up and we get to that point right there. Similarly, you could have shifts in the supply of loanable funds. Let's say, for example, the savings rate changes for some reason. There's a big marketing campaign from the government or in education or in schools that say, hey, we need to save more for a rainy day. You need to save more for our retirement. Well, then the supply of loanable funds, if everyone saves more at any given real interest rate, well, then the supply for loanable funds curve could shift to the right, and if the opposite happened, of course it would shift to the left. Supply of loanable funds two, and then what would happen? Well, if we were at this point right over here, all of a sudden we are in a situation where there's a surplus of loanable funds. At this interest rate, people are willing to supply way more loanable funds than people are demanding, so then the price of the loanable funds, which is the real interest rate, will go down. It will go down to this new equilibrium point, and so here, this, we could call this R sub three would be our new real interest rate, equilibrium real interest rate, and this would be our new equilibrium quantity. Actually, let me call this R sub two right over here. So, I will leave you there. The big takeaway is that loanable funds kind of operate the way the market for almost anything would with the difference being that the price is no longer just a dollar amount, it is an interest rate and since we wanna factor out inflation, it is a real interest rate.