13.3 The Market of Loanable Funds

13.3 a. Supply and Demand for Loanable Funds

Lenders are consumers or firms that decide that they are willing to forgo some current use of their funds in order to have more available in the future. Lenders supply funds to the loanable funds market. In general, higher interest rates make the lending option more attractive. ^[12]

A firm’s decision to acquire and keep capital depends on the net present value of the capital in question, which in turn depends on the interest rate. The lower the interest rate, the greater the amount of capital that firms will want to acquire and hold, since lower interest rates translate into more capital with positive net present values. The desire for more capital means, in turn, a desire for more loanable funds. Similarly, at higher interest rates, less capital will be demanded, because more of the capital in question will have negative net present values. Higher interest rates therefore mean less funding demanded. ^[12]

^{Supply and Demand for Loanable Funds [18]}

13.3 b. Policy 1: Saving Incentives

Adopting tax reforms that promote greater saving increases the supply of loanable funds, decreasing the interest rates and result that boosts investment. ^[12]

Example: Low interest stimulates consumption as consumers burrow money for larger expenditures. ^[13]

^{Saving Incentives [14]}

13.3 c. Policy 2: Investment Incentives

Tax reforms that encourage greater investment would cause more demand, resulting in higher interest rates and thus more savings. ^[12]

Example: If a firm already has cash, then higher interest rates would induce the business to lend out the money rather than attempt risky projects in the hope of earning a higher return, especially when consumer demand is slack. ^[13]

^{Invest Incentives [19]}

13.3 d. Policy 3: Government Budget Deficits and Surpluses

Budget deficits – also known as fiscal deficits – occur when a government’s spending is higher than its tax revenues. Conversely, budget surpluses – also called fiscal surpluses – occur when a government’s tax revenues exceed its spending. ^[15]

When a government runs a budget deficit, the government borrows more money. ^[15] This decreases the supply of loanable funds. This increases the interest rate and investment falls.

Conversely, when a government runs a budget surplus, the supply of loanable funds increases, interest rate decreases and the investments flourish.

Example: The Greek debt crisis of 2009 happened when the budget deficit of 2009 would be 12.9% of the GDP, risking a debt default. The EU and International Monetary Fund provided a bailout of 240 billion euros. ^[16]

^{Budget Deficit and Surplus [17]}