Borrowing and lending help drive economic activity in the modern economy. Loans allow consumers to make purchases like buying homes, cars and tuition that they would likely not be able to make otherwise; this allows businesses to turn a profit and expand. The demand for credit or loanable funds describes how much money consumers and businesses in an economy wish to borrow. Demand for loanable funds can increase during periods of economic expansion for several reasons.
Consumer confidence is the level of optimism that consumers have about the current state of the economy. When an economy is in recession, consumer confidence tends to be low due to factors like high unemployment and worries about job security. Low confidence in the economy typically makes consumers demand fewer loanable funds, because they not be able to pay back their loans. During economic expansions, consumer confidence tends to be high so consumers are more optimistic about being able to pay back loans and will demand more loanable funds.
Business profit is another factor that can lead to an increase in the demand for loanable funds during expansionary periods. When business face hard times, they tend to take out fewer loans, since they may not have enough cash flow to pay the interest on loans; it is also possible that the business might not have enough consumer demand to merit an expansion. During economic expansions, demand for goods and services tends to be high, which can make them demand more loans to capitalize on the favorable business environment.
Expansionary periods are often associated with increases in disposable income among the average consumer. When the economy is expanding, unemployment tends to fall and compensation for work tends to rise. Lower unemployment and higher pay means consumers have more money to spend, which will make them more likely to demand loanable funds for large purchases like homes and cars.
Higher interest rates tend to decrease the demand for loanable funds because high interest makes loans more costly. Interest rates may be very low during economic recessions because the government can set bank interest rates low to encourage lending and economic growth. Interest rates may rise during economic expansions, especially if the government increases the rates it controls.