Supply of Loanable Funds

Determinants of the Supply of Loanable Funds

One of the main determinants of the supply of loanable funds is the interest rate. The interest rate provides the return individuals receive for loaning their money to borrowers.

Figure 1. Supply in the Loanable Funds Market

Figure 1 shows the supply of loanable funds. Notice, that as the interest rate increases, the quantity of loanable funds supplied increases. This means that there is a positive relationship between the interest rate and the supply of loanable funds.

To better understand why there is a positive relationship between the supply of loanable funds and the interest rate, let’s consider an example.

The Source of the Supply of Loanable Funds

What is the source of the supply of loanable funds? The answer is - individuals' savings.

Saving is the portion of income that households and individuals do not consume. Saving is the source of supply for loanable funds.

Let's consider savings at a macroeconomic level.

Remember that the gross domestic product (GDP) refers to the total revenue in an economy and the total spending on the goods and services produced.

The gross domestic product, often denoted as Y, is broken down into four distinct categories of spending: consumption (C), investment (I), government purchases (G), and net exports (NX).

The equation for GDP is written as:

$$\begin{gathered} Y=C+I+G+NX \\ where: \\ Y-GDP \\ C-consumption \\ I-investment \\ G-governmentpurchases \\ NX-netexports \end{gathered}$$

Let's first assume that it is a closed economy.

In particular, a closed economy does not participate in the international commerce of commodities and services.

Additionally, a closed economy does not participate in international borrowing or lending.

Since a closed economy does not participate in international commerce, the amount of imported and exported goods equals zero. As a result, the net exports (NX) component of GDP is equal to zero.

In this scenario, we may express Y as the following equation:

$$\begin{gathered} Y=C+\hspace{0.17em}I+G \\ where: \\ Y-GDP \\ C-consumption \\ I-investment \\ G-governmentpurchases \end{gathered}$$

According to this equation, the gross domestic product (GDP) equals the sum of the total consumption, investment, and government purchases.

Deducting C and G from both sides of this equation will allow us to determine what this identity may teach us about the financial markets.

We get the following equation:

The total income in the economy is shown on the left side of this equation (Y - C - G), which is the amount left over after accounting for consumption and government spending.

In other words, when you deduct government spending and individual consumption from the national income you get national savings. Nationwide savings is the total amount of savings in an economy or the portion of GDP that is saved and not spent.

Let's further denote national saving with S.

The above equation could be re-written as:

$S=I$

This means that national saving provides the main source of investment in a closed economy.

We've seen that the national saving is equal to the investment in a closed economy, where there is no international borrowing or saving.

However, investment equals national savings and capital inflows coming from other countries in an open economy.

Supply of Loanable Funds Shifters

When the interest rate changes, there is a movement along the supply of loanable funds curve, but what about the shifters of the supply of loanable funds? Other external factors such as private savings behavior and capital inflows cause the supply for loanable funds curve to shift.

Supply of Loanable Funds Curve

How does the shift in the supply of loanable funds curve look like?

Figure 2. Shift in the supply of loanable funds, StudySmarter Originals

Figure 2 shows an example of a leftward shift of the supply in the loanable funds market. Holding demand constant, a leftward shift in the supply of loanable funds causes the interest rate to increase and the total quantity of loanable funds available to drop. On the other hand, a rightward shift in the supply for loanable funds would cause the interest rate to drop and the quantity of loanable funds to increase.

Private Savings Behavior

The average percentage of a family's income put aside for savings differs across countries. Private saving behaviors strongly affect the loanable funds market by changing the supply of loanable funds. When you have a higher saving rate, the supply for loanable funds will shift to the right lowering the interest rate, which would cause more investment to take place in an economy.

Capital Inflows

Capital inflows refer to the money that is invested in an economy by foreign investors. Capital inflows affect the amount of financial capital that is available for borrowing.

When foreign investors are bullish on a country's long-term economic growth and start investing in the country, more money will be available for borrowing, thus, shifting the supply of loanable funds to the right, resulting in a lower interest rate.