Loanable Funds Theory
Economists offer a simple model for understanding financial markets and how the real interest rate is determined. This hypothetical market, referred to as the loanable funds market, exists to bring together “savers” and “borrowers.” Savers supply, and borrowers demand the part of savers' incomes that are not spent on goods and services. The real interest rate occurs at the point where the amount saved equals the amount borrowed.
According to the law of supply, producers are only willing to offer more if they can collect a higher price because they face ever-increasing costs. In the loanable funds market, the price is the real interest rate. Savers, the producers of loanable funds, respond to the price by offering more funds as the rate increases and less as the rate decreases. Borrowers act as consumers of loanable funds — their behavior is explained by the law of demand. When the interest rate is high, they are less willing and able to borrow, and when interest rates are low, they are more willing and able to borrow.
Newcomers to economics are often confused by the use of the term investment. In economics, investment means borrowing in order to purchase physical capital. If the topic is stocks and bonds, then investment is understood to mean pretty much the same thing as saving. Savers engage in financial investment, which provides the funds for borrowers to engage in capital investment.
According to the expanded view of the loanable funds theory, savers are represented by households, businesses, governments, and the foreign sector. Borrowers also are represented by these same sectors. Changes in the saving and borrowing behavior of the various sectors of the economy result in change in the real interest rate and change in the quantity of loanable funds exchanged. For example, a decision by foreign savers to save more in the United States results in a lower real interest rate and a greater quantity of loanable funds exchanged for the country. A decision by the U.S. government to borrow money and engage in deficit spending would increase the demand for loanable funds and result in a higher real interest rate and a greater quantity of loanable funds exchanged. The loanable funds theory of interest rate determination is useful for understanding changes in long-term interest rates.