Question

write a paper of 2 pages about the loanable fund model

Answer 1

The loanable funds model is used to derive the market interest rate by using the supply and demand of loanable funds.
Detailed Explanation:

Savers or investors supply money to fund economic growth. Borrowers use (demand) the money provided by savers (suppliers) to fund their needs and compensate the saver (interest) for using their money. Bankers are both borrowers and investors. When you deposit money in a savings account you are an investor and the banker is borrowing your money. The bank pays you interest for the use of your money. The bank then becomes an investor by using your money to lend to consumers and businesses. For a bank, loans made to borrowers are investments, and banks expect to be paid interest for the use of their money. Savings, (investment), and borrowed money must be equal because whenever there is an investor (saver), there is a borrower. (Visit Monetary Policy – The Power of an Interest Rate to review the math proving that savings must equal investment.)

Supply of Loanable Funds

Interest rates and the supply of loanable funds are directly related. In the liquidity preference model, John Maynard Keynes contends that people prefer holding cash and must be paid to give cash up. Higher interest rates entice people to invest more than lower interest rates because the opportunity cost of having money sit idle increases. Two large suppliers of loanable funds include banks, when they originate loans, and investors when they purchase interest-bearing assets such as bonds or certificates of deposit. For example, investors frequently switch some of their stock portfolio to bonds following an increase in interest rates. A central bank can also directly influence the supply of money available for credit by increasing or decreasing the money supply.  

The graph below is a supply and demand graph, where four percent is the equilibrium real interest rate and $100 billion equals the loanable funds made available at four percent. (The implication is that there is only one market rate. Clearly this is false because there are literally thousands of interest rates. However, all rates tend to move in sync, so students should view this as an average real interest rate.)