Loanable funds refers to financial capital available to various individual and institutional borrowers. For example, individual borrowers include homeowners taking out a mortgage, while institutional borrowers could be a government issuing bonds or a company borrowing directly from a bank. Banking and financial services rely heavily on loanable funds to lend to borrowers with interest. This interest significantly increases the profit margins of these entities, while also increasing business. Each financial institution has several sources of funding.
Bond markets and financial institutions provide a means for those with excess cash to receive compensation for saving their money. In turn, these excess funds provide the financial capital needed for individuals and institutions to invest in a particular asset. For example, a bank will use the money deposited into a savings account by one man for a loanable fund for a woman purchasing a home. Alternately, an investment in an interest bearing bond by one man will help fund the construction of a new factory by the company issuing the bond.
The most common source of loanable funds is from savings of individuals or institutions. When a person opens up a savings account, he is allowing a bank to use his money in exchange for a certain interest rate. The bank will in turn aggregate all of the individual deposits and lend large sums of money to individuals, such as home buyers, and institutions, such as businesses, in exchange for a higher interest rate than it pays its depositors.
Newly Created Money
While most economists consider savings to be the primary source of loanable funds in an economy, another important source is newly created money. The Federal Open Market Committee of the Federal Reserve System can introduce money into the American economy by creating money and allowing banks to borrow that money, which they can in turn lend to individuals and institutions, thereby increasing the supply of loanable funds.
External sources outside of the primary economy can also supply loanable funds. For example, a source of loanable funds for the American economy could be Chinese foreign investment. The purchase of American government debt by China increased the amount of capital available in the general economy, although it is particularly beneficial for financial institutions. For example, a Chinese company purchasing American corporate debt in the form of a corporate bond provides an external source of loanable funds that may otherwise be unavailable.
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- The Loanable Funds Theory
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