Question

1. Indicate the sources of demand for loanable funds, and discuss the factors that affect the demand for loanable funds.

2. What are the main sources of loanable funds? Indicate and briefly discuss the factors that affect the supply of loanable funds.

Answer 1

Sources of Demand for Loanable Funds:

According to the loanable funds theory, there are 3 sources of demand for loanable funds -

1. Investments
2. Hoarding
3. Dissaving

1. Investments: Investments are required for creation of capital assets or purchase of inventory for production of goods. Loanable funds will be required for making such investments and a suitable rate of interest will be applicable for acquiring those funds. An investor has to compare expected rate of return from the investment with the interest rate applicable on such a loanable fund to make a decision on investment.

2. Hoarding: Some people also want to hoard cash as idle balance, they are also one source of demand for loanable funds. Demand for such hoarding is explained by liquidity requirements of the hoarders.

3. Dissaving: An idea opposite to saving is called "dissaving". So if a person want to spend more than his income, he may also demand the loanable funds resulting into dissavings and hence demand for loanable funds.

Demand for loanable fund for investment/hoarding/dissaving will depend upon the rate of interest charged for the loanable fund. If interest rate is high demand for loanable fund will be low, and if interest rate is low, demand for loanable fund will be high. Hence demand for loanable fund and interest rate of the loanable fund share an inverse relationship. It can also be said that demand for loanable funds is a decreasing function of interest rate.

Sources of Supply of Loanable Funds:

According to the loanable funds theory, there are 4 sources of supply for loanable funds -

1. Disinvestments
2. Dishoarding
3. Savings
4. Bank Money

1. Disinvestments: This is opposite to "Investment". Disinvestment process can be described as process of wearing out of existing capital asset without replacement by a new capital asset. If the return on the existing capital is lower than the interest earned on loanable funds, then investor will be inclined to "disinvestment".

2. Dishoarding: A process opposite to "hoarding" will be called dishoarding. If a person hoards a lot of money and interest rates increase he will be inclined to dishoard the money at the higher interest rate and reduce his hoarding levels.

3. Savings: When a person earns more than his expenditure, the difference between his earning and expenditure is called "Savings", which is the most important source of supply of loanable funds. This fund is made available for those entities who have a demand for loanable funds.

4. Bank Money: Banks are the financial institutions who are major source of supply of loanable funds. They source funds at lower rates and provide loanable funds at higher rates to earn income for themselves. The process of providing loans by the banks is called creation of Credit, which adds to the supply of loanable funds in the market.

In all above 4 cases, supply of loanable funds is directly related to the interest rates. Supply of loanable funds increase when interest rate increases and supply of loanable funds decreases when interest rate decreases. Hence there is a direct relationship. It can also be said that supply of loanable funds is an increasing function of interest rate.

Demand/Supply Demand of Loanable Funds Supply of Loanable Funds Applicable Rate of Interest Rate of Interest

The relationship between interest rate and supply/demand of loanable funds is used to establish the applicable rate of interest at a given time. As shown in the diagram supply curve has a positive slope as supply is directly related to the interest rate and demand has a negative slope as demand has inverse relationship with interest rate. The point at which demand and supply curve of Loanable Funds intersect become our applicable interest rate. Any shift in either demand or supply or both will also result into a new equillibrium point and hence a new applicable interest rate.