How Interest Rates Are Determined: Loanable Funds Theory

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 2 answers a question that affects everyone: why do interest rates go up and down? The answer comes down to supply and demand for money, explained through what economists call the loanable funds theory.

The Loanable Funds Framework

Think of money as a product in a marketplace. Some people want to borrow it (demand). Others want to lend it (supply). The interest rate is the price of borrowing money. When demand is high and supply is low, the price (interest rate) goes up. When supply exceeds demand, it goes down.

The aggregate demand for loanable funds comes from four main groups:

Households borrow for homes, cars, and other purchases. When interest rates are lower, more households are willing to borrow. When rates go up, borrowing slows down.

Businesses borrow to fund projects and operations. They evaluate projects using net present value (NPV). When interest rates drop, the cost of borrowing drops, more projects have positive NPVs, and businesses want to borrow more.

The federal government borrows to cover budget deficits. Here is the interesting part: government demand for funds is mostly insensitive to interest rates. The government will borrow what it needs regardless of what it costs. Municipal governments are a bit more flexible and may delay spending if borrowing gets too expensive.

Foreign entities also demand U.S. funds. If interest rates in their home country are higher than U.S. rates, they have an incentive to borrow in the U.S. instead.

On the supply side, the largest providers of loanable funds are households through their savings. The supply curve slopes upward because people are willing to save more when interest rates are higher. The Federal Reserve also influences supply through monetary policy, which we will cover in later chapters.

The Equilibrium Interest Rate

The equilibrium interest rate is where the total demand for funds equals the total supply. If demand exceeds supply, there is a shortage of funds, and interest rates rise until balance is restored. If supply exceeds demand, there is a surplus, and rates fall.

The book uses a clean algebraic framework for this:

• DA = Dh + Db + Dg + Dm + Df (aggregate demand)
• SA = Sh + Sb + Sg + Sm + Sf (aggregate supply)

When DA equals SA, you have equilibrium. When DA is greater than SA, rates go up. When SA is greater than DA, rates come down.

What Moves Interest Rates

Five major forces push interest rates around.

Economic Growth

When the economy is growing, businesses see more profitable opportunities and want to borrow more. This shifts the demand curve outward, pushing rates higher. During a slowdown, the opposite happens. Fewer businesses want to borrow, demand shifts inward, and rates fall.

Inflation

When people expect prices to rise, behavior changes on both sides. Borrowers want to lock in purchases before prices go up, increasing demand for funds. Savers want to spend now rather than watch their purchasing power erode, reducing the supply of funds. Both forces push rates higher.

This connects to the Fisher Effect, one of the oldest ideas in interest rate theory. Irving Fisher proposed that the nominal interest rate equals the expected inflation rate plus the real interest rate:

i = E(INF) + iR

The real interest rate is what you actually earn after adjusting for inflation. If a savings account pays 5% but inflation is 3%, your real return is only 2%. When actual inflation exceeds expectations, borrowers benefit because they repay with cheaper dollars. When inflation comes in lower than expected, lenders benefit.

Monetary Policy

The Federal Reserve can directly influence the supply of loanable funds. When the Fed increases the money supply, it adds funds to the banking system, shifting the supply curve outward and pushing rates down. When it reduces the money supply, rates go up.

During the fall of 2008, the Fed flooded the banking system with money to push rates down. It kept doing this through 2013 to keep borrowing cheap and encourage spending.

Budget Deficits

When the government runs a large deficit, it borrows heavily, competing with private borrowers for the same pool of money. This is called the crowding-out effect. The government will pay whatever rate it takes to get the funds it needs. Private borrowers might not be able or willing to match that, so they get squeezed out.

Foreign Fund Flows

Money flows internationally based on where returns are best. If U.S. rates are high relative to other countries, foreign investors send money here, increasing the supply and helping keep rates from going even higher. But if foreign interest rates rise, funds may flow out of the U.S., reducing supply and pushing domestic rates up.

The book compares the loanable funds markets for U.S. dollars versus Brazilian real. Brazil’s higher inflation at the time meant much higher interest rates because savers needed more compensation and borrowers were willing to pay more to buy before prices rose further.

Forecasting Interest Rates

The chapter ends with a framework for forecasting. The key is to forecast the net demand for funds (ND = DA - SA). If ND is positive, expect rates to rise. If negative, expect them to fall.

To do this, you need to assess:

• Future business expansion plans
• Expected government spending and tax revenues
• The Fed’s likely monetary policy
• Foreign economic conditions
• Consumer borrowing and saving trends

The book shows how all these factors played out historically. Interest rates dropped from 2000-2003 during a weak economy, rose during 2005-2007 as growth returned, then collapsed to near zero after the 2008 crisis as the economy tanked and the Fed pumped money into the system.

My Take

The loanable funds framework is one of those things that seems obvious once you learn it, but gives you a much clearer lens for understanding the news. Every time you hear about the Fed changing rates or the government running a bigger deficit, you can trace through the supply and demand effects.

The Fisher Effect is especially useful. It is a reminder that the interest rate on your savings account is only part of the story. What matters is the real rate after inflation. A 4% return sounds great until inflation is running at 5%.

The forecasting section is honest about its limitations. Nobody can perfectly predict interest rates because there are too many moving parts. But understanding the framework at least tells you which direction to watch.

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