The loanable funds theory describes the ideal interest rate for loans as the point in which the supply of loanable funds intersects with the demand for loanable funds. Under this theory, the loanable funds market is evaluated by building on a classical market analysis, with loanable funds acting as the "product" and the real interest rate (the interest rate after accounting for inflation) acting as the "price".
The loanable funds theory analyzes the ideal interest rate with a linear regression in which the quantity of loanable funds is plotted on the X axis and the real interest rate is plotted on the Y axis. Then, two data sets form two lines on the graph: demand for loanable funds and supply for loanable funds. Where these two lines intersect is the equilibrium interest rate, or the ideal interest rate for both parties to maximize the advantage of using loanable funds.
Demand for Loanable Funds
According to the loanable funds definition, the people who "demand" loans are the borrowers. Borrowers are willing to pay interest rates in order to secure assets in the form of business opportunities, houses, etc.
On the line graph, the demand for loanable funds line slopes downward. When the real interest rate is high, borrowers are not motivated to take out loans, and thus the quantity of loanable funds remains low. However, if the real interest rate is low, there's plenty of incentive for borrowers to take out loans, so the demand for loanable funds is high.
Supply for Loanable Funds
On the other hand, the people who supply loans are those who have some sort of savings. These individuals, businesses or institutions are willing to loan out their savings in order to allow the money to grow via an interest rate. Therefore, the supply for loanable funds line shows a positive slope.
When the real interest rate is low, suppliers have low motivation to lend out their money because it won't help to grow their savings and wealth. Thus, the quantity of loanable funds also remains low. However, with an increase in the real interest rate comes a willingness to increase the quantity of loanable funds, and the relationship between the two variables shares a positive correlation.
With a basic understanding of the trajectory that both supply and demand take on average, it's also important to understand the motivation for the supply and demand of loanable funds. Each motivation skews the line graph slightly and alters the equilibrium. If you're supplying loans to people seeking investments, for example, you can potentially charge a higher real interest rate without experiencing a drop in demand. Economists recognize three major motivating factors for the supply and demand of loanable funds.
From Where Does Demand Come?
One reason people take out a loan is to invest it in their business. They believe that using the funds to purchase necessary equipment, rent a storefront or pay for marketing will allow them to increase their business's revenue. If the business makes enough profit, then paying off a higher interest rate isn't quite so problematic. Thus, if the demand for loanable funds comes from the perspective of investment, the line shifts to the right, and the suppliers can charge a higher real interest rate for the same demand for loanable funds.
On the other hand, if the demand for a loan comes from a desire to simply spend money that the borrower doesn't have in order to purchase a luxury item or something that offers no investment (a situation economists call "dissavings"), the borrower's motivation decreases even more as the interest rate increases. You'll have to charge a lower real interest rate for the same quantity of loanable funds if your borrowers are motivated by dissavings.
A third cause of demand known as "hoarding" creates a trend line that tends to fall in between the lines for investment and dissavings. Hoarding occurs when someone wants to have an idle liquid cash balance with no immediate use for it.
From Where Does Supply Come?
Suppliers' source of loanable funds can determine whether they're willing to loan money at a higher or lower real interest rate. For example, the savings of an individual or business can become loanable funds, but only if the supplier (the owner of the savings) believes he can profit enough from having his savings enter the loanable funds market. Therefore, the savings line tends to shift furthest to the right, requiring the highest demand for loanable funds for the same interest rate.
Dishoarding, or allowing liquid cash to enter the loanable funds market, is another source of these funds. This cash is normally idle and "safe" as a liquid asset, but a high-enough interest rate or demand for loanable funds can motivate the supplier to move this hoarded cash into the loanable funds market. Existing between the dishoarding and savings trend lines is bank money, which can come from both sources and be loaned out by the bank for the right interest rate.
Shifting furthest to the left as a source of loanable funds is disinvestment. As assets depreciate, remaining profits may be added to the loanable funds market in order to turn a greater profit than the original asset. Because the supplier is looking to break even or make a marginal profit, these funds are more likely to enter the market despite a low demand for loanable funds for the same interest rate.
"Crowding Out" in the Loanable Funds Theory
Although it's important to understand the sources for supply and demand and how they work, ultimately, they average into an equilibrium rate of interest, or a guideline that affects the competitiveness of the real interest rates on all loans. An equilibrium rate of interest that's too low can slow the loanable funds market by demotivating suppliers, whereas an equilibrium rate of interest that's too high can also slow the market by demotivating borrowers.
If a single large entity manages to influence the equilibrium rate of interest and shift it significantly, the entire loanable funds market can be effectively forced to raise or lower interest rates in order to remain competitive. That single large entity is often the government, which can end up borrowing huge amounts of money at any given interest rate, thus adding to the demand for loanable funds and shifting the equilibrium interest rate to the right. When the demand shifts, the equilibrium interest rate jumps. This in turn can lead to a decrease in the demand for loanable funds due to individuals and businesses being unwilling to take out loans at a higher interest rate.
Thus, the impact of the government borrowing crowds out other borrowers, making it harder for them to enter the loanable funds market. The further effect of this crowding-out phenomenon includes a slower economy thanks to fewer borrowers investing in their business. With less business investment comes less production, fewer sales and a decreased amount of capital production. Therefore, the loanable funds theory plays an important part in the overall economy.