Factors That Cause the Supply and Demand
Curves for Loanable Funds to Shift
While we have alluded to the fundamental factors that cause the supply and demand curves for loanable funds to shift, in this section we formally summarize these factors. We then examine how shifts in the supply and demand curves for loanable funds determine the equilibrium interest rate on a specific financial instrument. A shift in the supply or demand curve occurs when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate. In either case, a change in the supply or demand curve for loanable funds causes interest rates to move.
Supply of Funds. We have already described the positive relation between interest rates and the supply of loanable funds along the loanable funds supply curve. Factors that cause the supply curve of loanable funds to shift, at any given interest rate, include the wealth of fund suppliers, the risk of the financial security, future spending needs, monetary policy objectives, and economic conditions.
Wealth. As the total wealth of financial market participants (households, businesses, etc.) increases, the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. For example, as the U.S. economy grew in the mid-2000s, total wealth of U.S. investors increased as well. Consequently, the supply of funds available for investing (e.g., in stock and bond markets) increased at every available interest rate. We show this shift (increase) in the supply curve in Figure 2–4(a) as a move from SS to SS ″. The shift in the supply curve creates a disequilibrium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls, from i * to i *″ , which is associated with an increase in the quantity of funds loaned between fund suppliers and fund demanders, from Q * to Q *″ .
Conversely, as the total wealth of financial market participants decreases, the absolute dollar value available for investment purposes decreases. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (traded).
Risk. As the risk of a financial security decreases (e.g., the probability that the issuer of the security will default on promised repayments of the funds borrowed), it becomes more attractive to suppliers of funds. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right, from SS to SS ″ in Figure 2–4(a) . Holding all other factors constant, the increase in the supply of funds, due to a decrease in the risk of the financial security, results in a decrease in the equilibrium interest rate, from i * to i *″ , and an increase in the equilibrium quantity of funds traded, from Q * to Q
While we have alluded to the fundamental factors that cause the supply and demand curves for loanable funds to shift, in this section we formally summarize these factors. We then examine how shifts in the supply and demand curves for loanable funds determine the equilibrium interest rate on a specific financial instrument. A shift in the supply or demand curve occurs when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate. In either case, a change in the supply or demand curve for loanable funds causes interest rates to move.
Supply of Funds. We have already described the positive relation between interest rates and the supply of loanable funds along the loanable funds supply curve. Factors that cause the supply curve of loanable funds to shift, at any given interest rate, include the wealth of fund suppliers, the risk of the financial security, future spending needs, monetary policy objectives, and economic conditions.
Wealth. As the total wealth of financial market participants (households, businesses, etc.) increases, the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. For example, as the U.S. economy grew in the mid-2000s, total wealth of U.S. investors increased as well. Consequently, the supply of funds available for investing (e.g., in stock and bond markets) increased at every available interest rate. We show this shift (increase) in the supply curve in Figure 2–4(a) as a move from SS to SS ″. The shift in the supply curve creates a disequilibrium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls, from i * to i *″ , which is associated with an increase in the quantity of funds loaned between fund suppliers and fund demanders, from Q * to Q *″ .
Conversely, as the total wealth of financial market participants decreases, the absolute dollar value available for investment purposes decreases. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (traded).
Risk. As the risk of a financial security decreases (e.g., the probability that the issuer of the security will default on promised repayments of the funds borrowed), it becomes more attractive to suppliers of funds. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right, from SS to SS ″ in Figure 2–4(a) . Holding all other factors constant, the increase in the supply of funds, due to a decrease in the risk of the financial security, results in a decrease in the equilibrium interest rate, from i * to i *″ , and an increase in the equilibrium quantity of funds traded, from Q * to Q
Conversely, as the risk of a financial security increases, it becomes less attractive to suppliers of funds. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. Holding all other factors constant, the decrease in the supply of funds due to an increase in the financial security’s risk results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (or traded).
Near-Term Spending Needs.
Near-Term Spending Needs.
When financial market participants have few near-term spending needs, the absolute dollar value of funds available to invest increases. For example, when a family’s son or daughter moves out of the family home to live on his or her own, current spending needs of the family decrease and the supply of available funds (for investing) increases. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant, reacts to this increased supply of funds by decreasing the equilibrium interest rate and increasing the equilibrium quantity of funds traded. Conversely, when financial market participants have increased near-term spending needs, the absolute dollar value of funds available to invest decreases. At every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a disequilibrium in the financial market that results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (or traded).
Economic Conditions.
Economic Conditions.
Finally, as the underlying economic conditions themselves (e.g., the inflation rate, unemployment rate, economic growth) improve in a country relative to other countries, the flow of funds to that country increases. This reflects the lower risk (country or sovereign risk) that the country, in the guise of its government, will default on its obligation to repay funds borrowed. For example, the severe economic crisis in Argentina in the early 2000s resulted in a decrease in the supply of funds to that country. An increased inflow of foreign funds to U.S. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. Accordingly, the equilibrium interest rate falls and the equilibrium quantity of funds loaned or traded increases
Conversely, when economic conditions in foreign countries improve, domestic and foreign investors take their funds out of domestic financial markets (e.g., the United States) and invest abroad. Thus, the supply of funds available in the financial markets decreases and the equilibrium interest rate rises, while the equilibrium quantity of funds traded decreases.
Demand for Funds.
Demand for Funds.
We explained above that the quantity of loanable funds demanded is negatively related to interest rates. Factors that cause the demand curve for loanable funds to shift include the utility derived from assets purchased with borrowed funds, the restrictiveness of nonprice conditions on borrowing, and economic conditions
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