Loanable funds

In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption. Savers supply the loanable funds; for instance, buying bonds will transfer their money to the institution issuing the bond, which can be a firm or government. In return, borrowers demand loanable funds; when an institution sells a bond, it is demanding loanable funds. Another term for financial assets is "loanable funds", funds that are available for borrowing, which consist of household savings and sometimes bank loans. Loanable funds are often used to invest in new capital goods, therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds.harvnb|Wessels|2000|p=102] cite web|accessdate=2008-10-04|url=http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/Capital-Loanable-Funds-Interest-Rate.topicArticleId-9789,articleId-9787.html|title=Capital, Loanable Funds, Interest Rate |publisher=CliffsNotes ] harvnb|McConnell|2005|p=547]

Interest rate

The suppliers are people who save money. The demanders are people who borrow the money. The interest rate is the cost of borrowing or demanding loanable funds and is the amount of money paid for the use of a dollar for a year. The interest rate can also describe the rate of return from supplying or lending loanable funds. It is typically measured as an annual percentage rate. As an example, consider this: a firm that borrows $10,000 in funds for one year, at an annual interest rate of 10%, will have to pay the lender $11,000 at the end of the year. This amount includes the original $10,000 borrowed plus $1,000 in interest; in mathematical terms, this can be written as $10,000 × 1.10 = $11,000. To continue with this example, if the firm borrows $10,000 for two years at an annual interest rate of 10%, it will have to repay the lender $12,100 at the end of two years. Because the loan lasts for two years, the firm will not have to pay the lender until the end of the second year. The firm is charged compound interest during the second year.

Equilibrium

In the loanable funds market, when savings equal investment, equilibrium occurs. To determine the equilibrium, the following formula is used:

: $ext\{national\; savings\}\; =\; ext\{domestic\; investment\}\; +\; ext\{net\; foreign\; investment\},$

or

: $S\; =\; I\; +\; NFI.,$

Rate of return on capital

The "rate of return on capital" is taken into account when determining the demand for loanable funds. This is the additional revenue that a firm can earn from its employment of new capital, and is usually measured as a percentage rate per unit of time, which is why it is called the rate of return on capital. As long as the rate of return on capital is greater than or equal to the interest rate on paid on funds borrowed, firms will continue to demand loanable funds.

Notes

References

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