Why the Loanable Funds Supply Slopes Up in a Large Open Economy
Understand why the supply of loanable funds slopes upward with interest rates, driven by domestic and global financial factors.
Understanding the flow of money available for borrowing and lending is important in a dynamic economy. These funds, known as loanable funds, are central to economic growth, financing investments that drive innovation and expansion. Like any other market, the market for loanable funds has a supply and demand, with the interest rate as its price. A supply curve illustrates that higher prices encourage more supply. This principle also applies to loanable funds, where the supply curve slopes upward, especially in a large, interconnected global economy. This article explores why the supply of loanable funds increases as interest rates rise in such an economy.
Understanding Loanable Funds and Interest Rates
Loanable funds represent the total pool of money within an economy that is available for borrowing and lending. This pool supports various activities, from businesses investing in new equipment to individuals purchasing homes. The primary sources contributing to this supply include household savings, where individuals choose to defer current consumption, and retained earnings from businesses, which are profits reinvested rather than distributed to shareholders. Government budget surpluses also add to loanable funds, occurring when tax revenues exceed government spending, leaving excess funds that can be lent out.
Conversely, the demand for loanable funds comes from entities seeking to borrow for investment or consumption. Businesses demand these funds to finance capital projects. Households borrow for significant purchases, while governments demand funds to cover budget deficits. The “price” of these loanable funds is the real interest rate, which represents the true cost of borrowing for borrowers and the actual return for lenders, adjusted for inflation. This rate reflects the purchasing power of money over time, guiding decisions about saving and borrowing.
How Domestic Savings Respond to Interest Rates
The real interest rate plays a significant role in influencing domestic savings behavior. For households, a higher real interest rate increases the financial reward for saving, making it more attractive to postpone current spending. For example, if a savings account offers a higher interest rate, the future value of those savings grows more quickly, encouraging individuals to save more.
Similarly, businesses consider the real interest rate when deciding how much of their profits to retain and reinvest versus distribute. A higher real interest rate means that funds held in savings or lent out can earn a greater return, potentially making internal investment projects less attractive by comparison. This encourages businesses to allocate more funds toward income-generating assets or to save them, thereby increasing the supply of loanable funds. Conversely, a lower real interest rate diminishes the incentive to save, as the return on deferred consumption or investment is reduced, leading to a smaller quantity of domestic savings supplied.
International Capital Flows and Loanable Funds
In a large open economy, the domestic supply of loanable funds is also significantly influenced by international capital flows. A large open economy is one substantial enough to influence global interest rates and attract considerable international investment. When the domestic real interest rate in such an economy rises relative to global rates, it becomes a more appealing destination for foreign capital. This differential attracts foreign investors seeking higher returns, leading to a net inflow of capital.
These capital inflows augment the total supply of loanable funds available within the domestic market. Conversely, if domestic real interest rates fall below global averages, capital may flow out of the country as domestic investors seek higher returns abroad, and foreign investors withdraw their funds. This net capital outflow reduces the total supply of loanable funds available domestically.
The Combined Effect on Loanable Funds Supply
The total supply of loanable funds in a large open economy combines domestic savings and net international capital flows. Both components show a positive relationship with the domestic real interest rate. As the real interest rate increases, domestic households and businesses are incentivized to save more, contributing a greater quantity of funds to the market. This direct response from domestic savers contributes to the upward slope of the supply curve.
Concurrently, a higher domestic real interest rate makes the economy more attractive to foreign investors. This results in larger net capital inflows, as international funds seek more favorable returns. Therefore, a rising real interest rate leads to a dual increase in loanable funds supplied: more funds from within the country due to increased domestic saving, and more funds from abroad due to greater capital inflows.