Grouping of all financial market in one category in macroeconomics is known as loanable fund market. So, it is an aggregate of all financial markets.
Funds that Finance Investment
Saving and investments are two prime activities with fund.
Funds which are used to invest in finance are as follows –
- Household saving
- Government budget surplus
- Borrowing from rest of this world
Suppose Y is the households’ income and amount spent on services and goods in households is C, saving is S and net taxes paid is T. Net Texas means the difference between taxes paid to the government and transfer of taxes rom the government. It means
Y = S + C + T
This explains that income is just equivalent to sum of Saving, Spent amount for services and goods and net taxes. It (Y) can also be explained as the sum of investment I, and government expenditure G, consumption expenditure C and exports X. Now, you just need to subtract M, or imports.
So, Y = C + I + G + X – M
These above two equations are there to explain that
S + C + T = C + I + G + X – M
S + T + M = I + G + X
I = S + M + T – G – X = S + (T – G) + (M – X)
It means I or investment is supported by saving of household S, surplus for government budget T-G and also taking or borrowing from anywhere or from rest of the world is M – X.
It is important to understand that T>G and this is completely suitable to apply for assets to finance investment, whereas in case of T<G means competes for funds along with investments.
In case of exporting is less than importing the borrowing would be (M-X). In case of importing is less than exporting, then lending is done for X –M. You may hear about the private saving S and the government saving T-G and these terms are known as National Saving.
If the investment is $2trillion and the government has taken role and deficit of $ 1.5 trillion. The total is $3.5 trillion. In that case if the sum is financed by private saving for 2.8 trillion dollars, then remaining fund is borrowed by rest of world. This is an exact way of understanding the loanable fund market.
In loanable fund market, interest rate, which is real, is measured by its price in the market. Henceforth, it is said that in loanable fund’s market, the interest rate is a single rate. It is just an average of all interest rate of financial securities.
The real interest rate
To understand an exact meaning of real interest rate, you should know about the nominal interest rate. When a borrower pays an amount and the lenders get an amount as an interest of that capital with an exact financial period suppose a year, then the percentage expressed for that interest is known as interest rate. For example if $ 25 is paid for $ 500 in a year, then you will get an interest rate as $25/ $500 * 100 = 5%.
Inflation rate is important to get adjusted. So, to adjust the nominal interest rate, requirement of real interest rate is there. What is a real interest rate? The real rate of interest is an exact difference between nominal interest rate with the inflation rate. It affects the exact value of money.
In normal case, if you have $ 500 as per 5% interest rate, then you will get $525 after ending of a year. However, if inflation is 2 %, then the exact value of money will be $510. So, what is the real increase of that amount? It will be only $525 – $ 510. It means the increase amount in the bank is just $15. You can also say that interest rate is 3 percent or $ 15.
The opportunity cost of the funds on loan or loanable funds is an exact or real interest rate. The paid funds for real interest rate for those which are borrowed is known as opportunity cost of borrowing. Forgone is the term used for real interest rate when funds is utilized to purchase consumption services as well a goods. In addition, these funds are also a part to use in investing new capital and not for lending or saving of these funds.
How real interest rate is related with the loanable funds market? How this is perfect for loan, saving and investment? It is better to understand the different types of loanable funds. These are as follows –
- The demand for loanable funds
- The loanable funds supply
- Equilibrium in the loanable funds market
The demand for loanable funds
The demand for loanable funds is the quantity of total number of funds demanded to government budget deficit, Finance investment or investment in a given period. Rather than other factors, it becomes important for you to consider the most accurate one and concentrate on investment. So, what is the essential for demand and investment in loanable funds for its financing? There are different details and all among them there are only two points as –
- Real interest rate
- The expected profit
A firm invests in capital to make its investment profitable only when there is a real interest rate at a higher value. So, it is important to know that if the interest rate is higher, then demand of quantity of loanable funds is smaller. In just opposite case, lower is the demand of quantity of loanable funds. So, an alteration in real interest changes an exact quantity of demand for loanable funds.
Demand for loanable fund curve – It is important to understand that Demand for loanable funds is an exact relationship between the real interest rate and quantity of demanded funds.
Anyone can understand this with a suitable example to clear all doubts. An online service provider amazon decided to have a new store or warehouse, and for that it had applied for the loan $100 millions. Now, it will follow its interest rate. So, consider that $ 5 million per year is the interest rate, and it means 5% is the right way to pay for amazon in return. Now, in case of increasing interest rate, amazon would be in loss. So, I left the decision of a new warehouse.
Changes in the Demand for Loanable Funds – Along with an expected change in profit of loanable fund, demand for these loanable funds also changes. All things beside it remains same and when there is an investment for a new capital, then amount for its investment is greater and thus demand of loanable fund is also greater.
It is very true that when a business expands and its business cycle expansions take place, then predictable profit increases. However, it goes just in opposite direction when there is a recession in business. In case of new products launch, and technology changes to provide latest products, demand will get increased as new products with latest technology is the prime requirement for people’s convenience. In this way demand of goods and services increase. In addition, pessimism and optimism for contagious swings also take place. These all features are known as “animal spirits” by Keynes and Alan Greenspan called it “irrational exuberance”.
The Supply of Loanable Funds
The loanable funds supply quantity is aggregate of all funds those are available from the surplus of government budget, international borrowing in a proper period and from private saving. Saving is an essential part of loanable funds supply. So, let us discuss about saving and this will clear your view about an exact quantity or portion for saving. What are the various factors that influence saving. These are –
- The real interest rate
- Disposable income
- Expected future income
- Default risk
When other things are kept same, then higher is the rate of real interest, the quantity of loanable funds will be greater. However, if there is small quantity supplied for interest rate, then it means there is lower real interest rate.
What about supply of the loanable fund curves? It is an exact relationship between the real interest rate and supplied quantity of loanable funds. It means if there is 2 percent interest rate for a year, then it will not work for those who desire to have some saving, as here the interest rate is lower and the person starts think of expends it in some other work to have a good profit. However, in case of 10 % interest rate, more and more people will come to take this service.
Changes in supply of the loanable funds – If there is a change in wealth, predictable income in future, change in disposal income or default risk, then there is a change in supply of the loanable funds.
Wealth – The higher value of the wealth and other things remain same, and then saving is minimal. It can be understandable as when prices of lands and houses increased rapidly in between 2006 and 2014, and then saving of individuals decreased. You can imagine that wealth increased means if the house rent increased, then a person must have less money to save in his account.
Disposal income – Disposal income indicates the earned income subtracts the net taxes. It means if disposal income is increasing and other things is same as before, then expenditure as well as consumption will be increasing. However, if this consumption is less than increased income, then saving takes place without any difficulty. It means greater value of household’s disposal income, by keeping other things as equal as before, there is higher value of savings.
Expected future income – If households’ income of expected future increase, by keeping other values same, then saving will be lower.
Default risk – If anyone is unable to repay his loan amount, then interest rate will increase. The risk will be greater and thus supply of loanable funds will be smaller.
Impact of shifting of curve for loanable supply – It is easier to explain tat if any factor gets influenced, then loanable curve shifts as supply of loanable curves change. A decrease value of expected future income, increase in income for disposal, wealth decrease, or any decrease in default risk can increase saving. So, curve in these cases shifts.
Equilibrium in the Loanable Funds Market
When value of other things is same, but the real interest rate is higher, then loanable funds supply quantity will be greater, and quantity of demanded loanable funds will be smaller. It is also true that there is a single position where quantity of loanable supply is completely equal to the quantity of loanable demand and this position if known as equilibrium of interest rate.
Curves of supply and curves of demand are responsible in determining the real interest rate. SLF is known as supply curve and DLF is known as demand curve. It is always said by the expert that if an exact real interest rate crosses 6 percent in a year, then quantity of supplied loanable funds exceeds the demanded quantity. It is just a surplus for that exact fund. At this time borrowers get it easier, but there are difficulties for the lenders. The interest rate starts falling and it will come down until the quantity of supplied fund and demanded fund will be equal. The same case goes in opposite direction if there is no real interest value up to 6% per year interest.
Now, supply will be lower than demand for loanable funds. In addition, the interest rate will increase and it will rise till both the quantities of demand and supply get equal.
It is always noticeable that the real rate of interest changes and it rises or falls to get that exact equilibrium. At 6 % there is neither shortage nor surplus of loanable funds. Thus, all borrowers can easily apply for the loan they desire and they get the exact amount. The saving plan for all lenders and the investment plan for all borrowers always get steady with one another.
Changes in Demand and Supply
Financial market in short term is highly volatile. However, if you go through the long term, then volatility becomes less and it is stable. One more thing that volatility also takes place because of fluctuation in the market and this fluctuation in the market takes place because of loanable fund’s supply or demand for that fund. The fluctuation in real interest rate as well as in funds with equilibrium quantity gets fluctuated time to time and lent and borrowed of funds also get a proper volatility.
Increase in demand
In case of increasing profit of a firm investment as per expectation, they try to work on the same plan for more expansion. So, demand of loanable funds to finance increases, but at the same moment supply is unavailable according to that. Now, you can say that borrowers compete for funds as they want, and thus interest rate increases. Lenders now increase the supply.
When there is a change in demand supply, then curve shifts to right side. However, there is no change in loanable funds supply. Here, the shortage of fund at the same rate of interest as 6% interest rate. Now, when there is change in the fund of supply at the same rate as 6 % interest rate. After that 7% interest is provided as this will be the increasing rate. So, funds of equilibrium quantity increase.
An increase in supply
If an impact on saving plan changes and saving gets increased, then loanable funds supply increases. However, in case of sufficient supply without having any change in demand, then quantity of loanable fund supply increases. So, there is flush with funds and at that time borrowers starts bargains and those who are lenders get very low interest rate. The supply increases when there is shortage of demand and so borrowers try to get its exact profit.
If SLF is the supply for loanable funds, then increase in quantity will shift the curve towards right only when there is constant demand. So, surplus of funds is there without having any change in demand. Now, the exact interest rate in a year will be lower from 6% to 5%. Restored equilibrium increases quantity of funds.
Long-Run Growth of Demand and Supply
It is true that both supply and demand gets fluctuate in the loanable fund market. So, the interest rate fall and rises. It is also true that after a long time, supply as well as demand of loanable funds will increase. On average rate demand and supply gets the position in a similar way, because if you go through the whole, then you can easily get that how it fluctuates in a constant manner. It means demand and supply have upward trend, the interest rate does not have any trend.