Interest Rates and Loanable Funds

Interest is the price paid for the use of money. Borrowers exchange the ability to purchase today in exchange for purchasing in the future — some of the money they receive in the future will be used to pay back the loan. Interest is almost always stated as a percentage of the amount borrowed, simplifying the comparison of different borrowing opportunities.

There are 3 main types of borrowers: consumers, businesses, and governments. Consumers borrow money to buy expensive items, such as cars or houses. Businesses borrow money to buy capital: goods and services that can be used to produce their output. Governments borrow to cover deficits. However, consumers are the main source of funds for lending, by saving and by providing funds to nondepository financial institutions, such as brokerages, insurance companies and pension funds.

Money can be saved, spent, or held. Lower interest rates promote borrowing and spending and discourage saving, while higher interest rates have the opposite effect. Low interest rates also promote liquidity, holding money for small purchases or emergencies. However, higher interest rates decrease liquidity because the opportunity cost of holding money.

Although opportunity cost can be measured in many ways, in economics, opportunity cost is used in the more restricted sense as a return forfeited by not saving it. In this sense, the opportunity cost of holding money is the nominal interest rate, which includes the real interest rate plus inflation. The reason why the opportunity cost is the nominal interest rate rather than the real interest rate is because the holding of money causes it to lose value when there is inflation. So, for instance, if the nominal interest rate is 5%, and inflation is 2%, then the real interest rate is 3%, but if the money is held as cash, then the opportunity cost is still 5%, because the 3% real interest rate is forfeited, and the inflation rate reduces the value of the held cash by 2%, for a net opportunity cost of 5%.

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Although businesses borrow money, money itself is not a resource, since it is not a factor of production that can be used as an input to produce an product or service. Rather, businesses use money to purchase real capital, such as equipment or supplies, or to hire labor.

There are many different interest rates, depending on the creditworthiness of the borrower. Because the federal government can print money, United States Treasuries, which are bonds issued by the United States government, pay the lowest rate of interest, because there is no credit default risk (although there may be some political risk, as evinced by recent episodes where Congress threatens to shut down the government and to not increase the debt limit unless they get their way). Other interest rates include the:

Although there are many different interest rates, economists talk about interest rates as if they are 1, because interest rates tend to move together, which can generally be referred to as the market rate or prevailing interest rate.
Interest rates are generally positive, because:

So the interest rate must be sufficient to compensate the lender for inflation, opportunity cost, and credit default risk.

Loanable Funds Theory of Interest

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Macroeconomics, which is the study of the economy as a whole rather than individual firms and households, considers interest rates to be set by the equilibrium between the supply and demand of money. However, since most money is not available for lending, it makes more sense to talk about the supply and demand for loanable funds, which is the amount of money available for borrowing.

Saving is a source of loanable funds and investment is the demand for loanable funds. The market for loanable funds is a market where those who have loanable funds sell to those who want loanable funds. The availability of loanable funds is determined by the amount of national saving, which is the total income in the economy — otherwise known as national income — after paying for consumption and government purchases.

It is the intersection of the supply and demand of loanable funds that sets the interest rate. Like the supply of anything, more loanable funds are available at higher interest rates, and vice versa. The demand for loanable funds, on the other hand, is inversely proportional to the interest rate — higher interest rates reduce demand. Under this simplified model of microeconomics, households are treated as a source of most loanable funds and firms are the demanders of loanable funds. Note, however, that lenders will not accept an interest rate that does not compensate them for their costs and risks, including the inflation premium, risk premium, and the opportunity cost of lending money.

Firms are the main borrowers of loanable funds, but they will only borrow if they can make an investment in real capital to produce a product or service that will have a higher return on investment than the interest rate being paid on loanable funds. For instance, if a firm can borrow money at 6% to invest in a project that will yield a 10% rate of return, then it would be prudent for the business to borrow the money. But if the interest rate on loanable funds is 12%, then it makes no sense to borrow the money, especially since there is always some risk in business enterprises. Obviously, higher interest rates reduce the number of viable projects that can be financed by loans. Indeed, during the credit crisis of 2007 - 2009 and afterwards, the interest rate was extremely low, but few firms borrowed the money for real investments, because there was a lack of consumer demand, and therefore, few projects would yield an investment return exceeding even the low rates that prevailed at that time. Instead, firms accumulated cash, saving for a future when the economy picked up enough so that it made sense to invest in real capital and to hire more labor.

The demand for loanable funds is limited by the marginal efficiency of capital, also known as the marginal efficiency of investment, which is the rate of return that could be earned with additional capital. Firms will have a choice of a range of projects ranging from the most profitable to the least profitable. The interest rate, among other factors, will determine which projects are profitable. Firms will pursue projects deemed most profitable first. Succeeding projects will yield a lesser return, but as long as the business has the resources and expertise to complete the projects, it can increase its profits by pursuing those projects.

If the project is a long-term investment, then whether the project will be profitable will depend on its net present value, which is the sum of the present value of all cash inflows minus the sum of the present value of all cash outflows. Net present value can be set to 0 by adjusting the interest rate, which in capital budgeting is often referred to as the discount rate or hurdle rate. Setting the discount rate so that the net present value equals 0 yields the interest rate showing the internal rate of return. For a project to be profitable, this internal rate of return must exceed the interest rate if the money is borrowed. In capital budgeting, the interest rate cost is often referred to more generally as the marginal cost of capital, which can also include costs to issue equity to finance the investment.

The marginal efficiency of capital declines with each succeeding project until the return from the investment no longer exceeds the hurdle rate, which will include a business-risk premium over and above the interest rate of the borrowed funds to justify any projects. This will increase the probability that the project will be profitable.

As an alternative view of the supply and demand for loanable funds, consider the fact that money is either saved or consumed. Economists use the term save as a general term to indicate any money invested to earn interest or to earn some other form of return, such as capital gains or dividends. Some money is held for liquidity, but this amount is negligible. The supply of loanable funds increases with increasing interest rate because there is a competition between using the money now for personal consumption and delaying consumption by lending the money out so that the lender will have more later on. If a firm already has cash, then higher interest rates would induce the business to lend out the money rather than attempt risky projects in the hope of earning a higher return, especially when consumer demand is slack. For consumers and businesses, the higher the interest rate, the higher the opportunity cost to not lend money.

High interest rates will also cause funds to flow from foreign countries, from foreigners seeking a higher return on their investment.

On the other hand, low interest rates stimulate consumption. Consumers borrow money for consumer items, especially for large purchases, such as a house or a car.

Non-Interest Supply and Demand Determinants Of Loanable Funds

While price is the main factor that determines the supply and demand of almost everything, there are other factors that can change supply and demand independently of price. These determinants shift the supply or demand curve either leftward or rightward, either decreasing supply or demand at any given price, or increasing it. Some of these factors for loanable funds include the same factors that affect demand or supply generally, including technology improvements, shift in consumer tastes, substitution possibilities, changes in income of consumers, taxes, and so on. There are also several factors that affect the supply and demand of loanable funds more specifically, including monetary policy, private and public saving, and investment tax credits.

Central banks the world over usually set monetary policy by manipulating the interest rate by increasing or decreasing the money supply. Although not all money is lent out, an increase in the money supply generally increases the supply of loanable funds, and vice versa. Low interest rates stimulate buying, which stimulates the economy. Likewise, higher interest rates cause consumers and businesses to save their money rather than borrow. Since inflation is generally an indication that the economy is overheating, central banks respond by restricting the money supply, which restricts the supply of loanable funds, thus increasing the interest rate, slowing the economy.

Private saving is the income that households have after paying for taxes and consumption. Although the rate of private saving is influenced by the interest rate, people also save for emergencies and to maintain liquidity. Private saving can also be increased by tax incentives or by taxing investment income less.

Public saving is the tax revenue that the government has left over after spending. Public saving is increased when the government has a budget surplus, which is the amount of tax revenue over government spending during the tax year. A budget deficit is a shortfall in tax revenue over government spending. A budget surplus will eliminate the need for the government to borrow money, while a budget deficit is financed by government borrowing. If the budget deficit is large, as it currently is for most of the modern economies due to the recent credit crisis, government borrowing could be so large that there is a crowding out effect, decreasing private investments, since they must compete with the government for funds.

Investment tax credits can shift the demand curve rightward by allowing firms to offset their research and development costs with tax credits. Many countries offer these credits to stimulate research and development for new products and services, which stimulates the economy, thereupon increasing tax revenue.

Range of Interest Rates

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Although economists like to talk about a single interest rate, there are actually a range of interest rates available to different borrowers according to their creditworthiness. Interest rates also vary with the term of the loan. In other words, there are demand and supply determinants other than the cost of loanable funds that shifts either the supply or demand curve to the right or left, thereby shifting the interest rate accordingly. Some of the major factors include the following:

Risk. Generally, the less creditworthy the borrower, the higher the interest that the borrower must pay to obtain funds. In other words, they must pay a risk premium to compensate lenders for the risk that they will not be paid back.

Inflation. Inflation is a major determinant of what is called the nominal interest rate. This reflects the fact that the lenders do not receive any money until sometime in the future, during which time inflation will reduce the real value of the return. Hence, some portion of the interest rate can be attributed to an inflation premium to compensate lenders for inflation risk and is proportional to the expected inflation rate over the term of the loan.

Maturity. Longer-term loans usually have higher interest rates, not only to compensate the lender for inflation risk, but also for credit default risk, since there is a greater risk in not being paid back as it becomes more probable that the borrower will run into financial difficulty. There is also liquidity risk, since the lender will not usually be able to recover the principal until the loan matures. Additionally, inflation lowers the real return to the lender that is proportional to the term of the loan.

Taxation of interest. If a lender lent $1000 at 8%, she would receive $80 per year, but if she had to pay a 25% tax on that, then she would end up with a net amount of $60 per year. This is equivalent to earning 6% on the loan tax-free. Hence, the lender will be indifferent to lending the money at 6% tax free or at 8% with a 25% tax assessed on the interest. So borrowers whose interest payments are tax-free to the lender, such as the interest earned from Treasuries or municipal bonds, can borrow at a cheaper rate. In the United States, people who buy Treasuries, which are securities issued by the federal government, do not have to pay either state or local tax on the interest. Likewise, municipalities and states can issue bonds whose interest is free from taxation by the federal government. In certain cases, the lender can buy municipal bonds which are exempt of all taxes – federal, state, and local. Although states or municipalities could tax the interest if they wanted to, they would just be forced to pay a higher rate of interest to compensate the lenders for the taxes.

Loan amount. There are certain costs to originating and servicing loans. Generally, these costs do not vary much with the size of the loan, so these costs will constitute a larger percentage of smaller loans.

Market imperfections. The actual interest rate paid by borrowers or received by lenders depends on the availability of information concerning interest rates and availability of funds. Since borrowers and lenders do not have perfect information about the market for loanable funds, there will be some deviation in the interest rates actually paid or received from the market interest-rate.

Although the above factors influence interest rates, economists sometimes talk about a pure rate of interest, which is simply the interest rate that would be charged for a loan that was completely risk-free with negligible administration costs and for which buyers can easily find current market information. Because treasury bonds exhibit these characteristics, the interest rate on Treasuries is thought to best reflect the pure rate of interest.

Resource Allocation by Interest Rates

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The price of loanable funds determines how the money is distributed, which in turn, determines the investment in real capital and in the production of products and services. If there is a strong demand for a product, consumers will tend to demand more, and be willing to pay a higher price for the product compared to its cost. This allows firms producing the product to earn a higher rate of return on their investment, which allows them to pay a higher rate of interest. Hence, loanable funds will be apportioned to those firms producing the most desirable products and services.

Another way that interest rates allocate resources is by the expected return on investments in research and development. With higher interest rates, only the most profitable R&D projects will be pursued. Projects with a lower expected return of investment will be delayed until lower interest rates are available.

Usury Laws

Some governments have usury laws that place a maximum on the interest rate that can be charged. This has the effect of limiting loans to more creditworthy customers and for less risky projects. In other words, usury laws set a price ceiling on the cost of loanable funds. Of course, the economic effect of usury laws depends on how the laws are actually implemented, but the usual result is the lower availability of loanable funds.