The amount of money in commercial banks and other lending institutions, less the reserves required by the Federal Reserve to protect bank liquidity, is known as loanable funds. These are important because they function as a money multiplier in the economic system. If you borrow money to buy inventory for your company, the suppliers you pay put that money in their banks, and it becomes loanable funds. Your bank may package your loan and sell it to an investment bank to use in collateralizing a debt security. The money your bank receives from selling your loan becomes loanable funds.
Each dollar of loanable funds supports many elements of the economy, including the manufacture of goods, commodities production, employee wages at your company and at your suppliers, the purchases made by employees at both companies, operations at the investment banks, debt securities in investment portfolios and so on throughout the system. When your customers buy from you on credit, you use that money to pay down your loan, which results in the debt securities held in portfolios paying back the principal. As the Federal Reserve raises interest rates, your customers typically pay off their credit cards, you delay buying inventory, your suppliers order less raw materials and investment banks issue fewer asset-backed debt securities.
Federal Reserve Monetary Policy
The Federal Reserve (Fed) mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” It does this by creating monetary policy and implementing it through setting interest rates and performing open market operations, in which it buys or sells Treasury securities in the open market. When the Fed wants to energize the economy, it adopts an expansionary monetary policy -- it adds money to the system by lowering reserve requirements, lowering interest rates and buying Treasury securities. When the Fed wants to cool down a booming economy and forestall inflation, it adopts restrictive monetary policy designed to remove money from the system through increased reserve requirements, sales of Treasury securities and higher interest rates that make lending more expensive.
When the Fed injects money into the system, that money eventually ends up in banks and lending institutions, becoming loanable funds. Low interest rates encourage business and consumer borrowing. High interest rates discourage borrowing and encourage saving and paying down debt. Because borrowing multiplies the money in circulation, saving and paying down debt contracts the money supply -- and has a similar effect on the supply of loanable funds.
Investment is the act of moving capital from one place to another in the hope of achieving a better return. When a company borrows money to buy inventory, facilities, equipment or to fund payroll for more employees, it is investing capital in its business. When a consumer borrows to buy a house or automobile, it is also capital investment. Low interest rates encourage this capital investment. It is not the same as investment in stocks and bonds, which qualifies as saving and removes money from the system. Because of the multiplier effect, all this borrowing serves to increase loanable funds.