Interest is a payment to providers of economic capital. Saving makes new capital supplies available; thus, the ultimate capital suppliers are savers. Just what factors determine the interest rate? After adjusting for inflation, the real interest rate depends on:
1. Premiums savers require to delay gratification. Most of us want goods now instead of later, unless we are rewarded for waiting. If 5 percent more goods are required to get typical savers to wait a year to consume their income, real interest rates gravitate toward 5 percent.
2. Premiums required for sacrificing liquidity. Less-liquid assets generate higher rates of return, or we would all hold cash.
3. Productivity of new capital. If new capital reproduces 6 percent of its value in new goods each year, interest rates tend toward 6 percent.
The first two items are reflected in the supplies of loanable funds; item #3 is reflected in the demand for loanable funds.
The total demand for loanable funds in the United States depends on the plans for borrowing by domestic consumers, business, government, and by foreigners. The supply depends on (a) the aggregate of plans for saving by individual households, (b) international flows of financial capital (by which foreign savers can make loans to U.S. borrowers, or vice versa), and (c) the monetary policy of the central bank.
Keep in mind that markets for loanable funds are affected by government deficits and debt, monetary policies, and international capital flows, but these are macroeconomic topics. The analysis of this section would not change in a meaningful way if we considered all the roles played by all the entities just listed. Therefore, for simplicity we will focus on household plans to save as sources of loanable funds, and on business borrowing as a use of loanable funds.
Demands for Loanable Funds
Some business borrowing is to cover current operating expenses, but we will concentrate on the investment plans that absorb the bulk of business borrowing. Firms construct buildings, buy machinery, or purposely increase inventories only if they expect to profit by doing so. Firms can finance these investments with funds from (a) retained earnings, (b) direct sales of the company's stock, and (c) sales of new bonds, or loans from financial institutions. Naturally, the depositors (savers) are the real lenders. The third approach is called debt capital. To simplify our analysis even further, we will focus on debt capital. Our analysis would change little if we separately considered each form of financial capital. Keep in mind that financial capital is merely a tool used to secure purchasing power over a wide range of goods, including economic (physical) capital.
Business investors demand funds for a variety of investments, each of which is expected to yield profits to the borrower. Just as the demand for labor depends on labor's marginal productivity, the demand for capital depends on its marginal productivity. Capital's marginal productivity (its MRP) as a percentage of expenditures on capital is known as the rate of return on investment (r). Like the demands for other resources, the demand for capital is a derived demand.
The demand for capital goods generates demand for loanable funds to finance new investment. In Figure 5, this demand for loanable funds is expressed in terms of rates of return and interest rates. One explanation for the negative slope of demand curves for capital and loanable funds is that, for the economy as a whole, greater investment causes more and more capital to be used with fixed amounts of land and labor. The law of diminishing marginal returns then causes successive doses of capital to be decreasingly productive.
Figure 5 The Demand Curve for Debt Capital (Loanable Funds)
An alternative approach is to recognize that firms rank potential investment projects from the highest expected rate of return to the lowest. Assuming that funds from retained earnings or new stock offerings are insufficient, these projects underpin the demand for loanable funds shown in Figure 5. Only a few projects will yield a 20 percent rate of return or greater ($1 billion worth in Figure 5). As the rate of return requirement falls, firms find that more projects are advantageous. If interest costs fall to 10 percent, $4 billion worth of projects are profitable (point b); $8 billion in new investments generate rates of return of at least 5 percent (point c).
Construction costs and equipment costs are obviously important determinants of business investment. Because the supply curves for capital goods are positively sloped, their costs and prices tend to rise during prosperity as demand for investment goods increases, choking off short-term surges in investment. Conversely, declines in the costs of investment goods during economic downturns slow the fall of investment spending.
Investors do most of the borrowing in this country, but consumers and all levels of government also borrow substantially. Consumer purchases of homes and automobiles fall sharply when interest rates rise. Although the federal government's borrowing sometimes seems unaffected by interest rates, state and local governments borrow more to finance schools, parks, and roads when their interest costs are less. Thus, when consumer, investor, and government demands for loanable funds are combined, the market demand curve slopes downward. As with all other markets, however, demand is only half of the story.
Supplies of Loanable Funds
The supply of loanable funds is positively related to the price received (interest). The ultimate lenders (savers who supply loanable funds) receive interest for the use of their funds. The major alternative for saver/lenders is current consumption, but a few, who value liquidity highly or who expect a financial crash, may hoard their savings. High interest rates confront individuals with high opportunity costs of current consumption or hoarding. As a result, many save (providing funds to the capital market) and use their future wealth (amount saved plus interest) for consumption at a later time.