Supply and demand forces in the market for loanable funds determine the economy’s equilibrium interest rate. Some households, firms, residents of other countries, and even governments make funds available to financial markets (usually through the banking system) while other households, businesses, residents abroad, and governments desire to borrow funds. The interest rate aligns the interests of these groups: the quantity of funds supplied equals the quantity of funds demanded at the equilibrium interest rate.
|Exploration: What factors determine the equilibrium rate of interest?|
The market for loanable funds is illustrated by the graph. The supply of loanable funds is upward sloping to reflect the desire of savers to save more at higher rates of interest: the higher the rate of interest, the higher is the opportunity cost of using funds today. The demand for loanable funds is downward sloping: investments that are profitable at low interest rates may not be profitable at high interest rates. Currently, the market is in equilibrium at the interest rate ie. To use the graph, shift either the supply or demand curve, as appropriate, by clicking and dragging the curve’s label. Once the curves are in place, click on the New Equilibrium button to observe the resulting changes in the interest rate and quantities of loanable funds demanded and supplied.