Question

part 1: Where does the supply of loanable funds come from? Draw it on a graph and explain why it has the slope it does (i.e., positive or negative)?

part 2: Where does the demand for loanable funds come from? draw it on a graph and explain why it has the slope it does?

part 3: draw a loanable funds market in equilibrium explain how equilibrium is achieved?

Answer 1

1)Supply of loanable fund comes from 4 sources :

savings : Saving are the difference between the consumption and income of individual . Higher the rate of interests , higher the level of savings .

dishoarding : it represents money saver from past income for speculation purposes . When the rate of interest is high , people dishoard money as opportunity cost of holding money increases .

disinvestment : this occurs when the existing capital stock is allowed to depreciate without providing for depreciation allowance . This money is rather used for supplying funds for loans

bank money : Banks continuously create money for purpose of lending to individuals and businessmen for various purposes.

Supply curve is upward sloping as the level of saving , disinvestment , dishoarding and bank money would increase as the interest rate increases.

part2 ) demand for loanable funds comes from the following sources :

investment : businesses tend to borrow money for the purpose of investment , expansion of machinery , building new plants . When the rate of interest rate is low , firms tend to borrow more as cost of borrowing is low.

hoarding : People tend to hoard money for precautionary purposes and to maintain some liquidity. It is a decreasing function of interest rate .

dissaving : People tend to dissave i.e spend more than their income to purchase durable goods etc . It

is also a decreasing function of interest rate as people tend to borrow more when interest rate is low.

therefore the demand curve for loanable funds has a negative slope . i.e demand for funds falls when interest rate is higher

part3 ) equilibrium is achieved at the level when demand for loanable funds = supply of loanable funds . If the supply of loanable funds > demand of of loanable funds , the interest rate will fall and vice - versa.

in diagram , equilibrium point occurs at E where the demand and supply curve intersects . Equilibrium quantity of funds = OL* and equilibrium interest rate == OR.