The loanable funds theory describes the relationship between money available for borrowing and interest rates. Both the supply of money available for borrowing and demand for money to be borrowed depend upon interest rates. The loanable funds market consists of borrowers and loaners of funds.
The Underlying Principle
The loanable funds market works on the principle of equilibrium. Demand for loanable funds will balance with the supply of loanable funds at a specific interest rate. The interest rate varies with market conditions, so the demand for -- and supply of -- loanable funds remain equal. Changes in either the demand for funds or the supply of funds will result in a change in interest rate to restore equilibrium. An increase in demand for funds, for example, causes an increase in the interest rate, which in turn increases the available supply. The opposite is also true. Consumers have access to loanable funds primarily through bank loans. Businesses and governments can also issue bonds to access loanable funds.