people borrow money for all kinds of reasons for most of us the only times we think about borrowing money is to buy a house or a car go to school or make some kind of big purchase but a more common reason people borrow money is to finance investment in a business there are lots of examples for why people need to do this Michaela might have the experience and know how to run her own urgent care facility but she doesn't have the money it would take to buy all the equipment she would need so she might turn to a bank to borrow two hundred and fifty thousand dollars to get started Tony might already have a successful HVAC repair business with several employees but it's a competitive industry in Tony's company operates with small profit margins if one of his trucks breaks down he might need a loan to finance the purchase of a new van or even if he just wants to hire another technician and have another van in his Fleet he might need a loan to finance that expansion meanwhile Christian might have a successful business which designs robotic equipment but he identifies 3D printers as a potentially lucrative new product line for his company he might need a loan to buy the equipment needed just to Tinker and toy with potential ideas and develop the product he thinks will be a big seller starting a business upkeep expansion and research and development are all common reasons that businesses or business owners will borrow money but they won't just do so without thinking about it first whether or not that borrowing is a good idea depends on how successful they expect that idea to be for example Michaela might project revenues for her first years in her business plan and those projections will mean she's only profitable if she gets an interest rate on her loan under five percent per year any higher and there would be a risk that even if her business is getting lots of customers she won't make enough money to pay back the loan Tony might have a better projection and the new van is sure to be worth it even if the interest rate on the loan is as high as seven percent but no higher while Christian might see this potential Market as worth pursuing only if he can get the loan under three percent interest notice that if the interest rate was three percent then these three people would borrow a total of three hundred and eighty thousand dollars because all three would find the terms agreeable but if the interest rate Rose to five percent a Christian would drop out and decide not to borrow the money so now the total amount borrowed would be two hundred and ninety thousand dollars and if the interest rate was seven percent Michaela would say that was too high and tote but Tony would still feel comfortable so only forty thousand dollars would be borrowed as the interest rate Rises fewer people borrow money and vice versa with millions of people and businesses and even governments like cities and towns looking to borrow money we can form the demand for loanable funds loanable funds are just the total amount of money that will be borrowed as the interest rate charged on the money borrowed goes down more and more business opportunities become feasible as does more and more borrowing for buying a home or a car or going to school so the demand for loanable funds is downward sloping as the price of borrowing the interest rate goes down the quantity of money borrowed the loanable funds goes up what this graph does is just describe how borrowers will react to changes in the interest rate but where does this money they're borrowing come from people and corporations save money for the future to entice them to deposit those Savings in a bank those banks will offer accounts which accrue interest most savings accounts Banks advertise these days offer pretty minuscule interest rates that are hardly worth it part of this is just a modern environment with low interest rates all around but other financial institutions like Goldman Sachs Robin Hood and synchrony offer better interest rates on money put into savings accounts with them but low interest rates means there's little gain to holding off on consumption if the interest rate you can earn on your savings is very high you might forego a new car or home renovation or even just cut back a little here and there to put more into the savings account higher interest rates means you will be earning a lot more each year and it might be worthwhile to postpone consumption now so you can buy even more stuff later for this reason we expect the amount of money people save in financial institutions or lend directly themselves by buying corporate or government bonds will increase as interest rates rise all this saving is what forms the supply of loanable funds as the interest rate Rises more and more people will be willing to park some of their money in an interest-bearing account from a financial institution which is pooling all those savings together and making loans with the money so the supply of loanable funds is upward sloping like this okay now let's put the two together the market for loanable funds consists of both the demand for loanable funds and the supply of loanable funds notice that this Market is just like any other we can represent with supply and demand there is a supply and demand for bread and the forces of competition push the price to the point where the quantity supplied is equal to the quantity demanded you may think that bread is different from money that you can actually go to a store and buy bread by paying some money for it but you can't go to a store and buy money by paying some money for it but actually you can it's just that the store is called a bank and the money you pay to buy some money is called the interest rate competition between Banks and other lenders will push the interest rate to the equilibrium where the amount people save and supply for loans is equal to the amount people want to borrow at that interest rate one thing that is really tricky about the market for loanable funds is that someone can be both on the supply side and the demand side take a big company like apple for example they do a lot of research and development and so they would typically need to borrow a lot to finance it but they're so profitable that they have plenty of cash just sitting around to spend you might have thought about an example like this yourself where a person has enough money themselves that they could start their business without borrowing but as any Economist would point out they are indeed borrowing from themselves they could take that extra money and stick it in an interest-bearing account earning the market interest rate on their savings by using their money to finance a business investment they are foregoing that interest and so in that way they are still paying the interest rate on the money they use for the investment remember economics is all about opportunity costs and the interest rate is the opportunity cost of using your money now instead of later but here are the key takeaways from the market for loanable funds interest rates are set by the market for loanable funds some large Banks might have enough market power to influence interest rates but for the most part the interest rates you have to pay on any loan is set by the forces of supply and demand the amount of investment is determined by this Market remember your solo model where we assumed that the population would save a fraction of their income and that savings would be used to pay for the investment needed to maintain the Capital stock after depreciation well now we have this model for loanable funds that explains how that savings rate and investment will be determined slowly but surely we're building an even better model for the economy at Large credit markets will segregate by risk level by that I mean that while we look at this as one big Market in reality there are a lot of different markets for loanable funds there is a market for mortgages a market for student loans a market for business loans a market for corporate bonds and so on each market has different fundamentals such as a different amount of risk that the loan won't be repaid nevertheless we can aggregate all those markets into this one big one for analysis but remember that this is basically representing the average of all of those markets setting the level of the interest rate from which all the other interest rates will be derived and lastly the supply of loanable funds is sensitive to Sentiments the money used to make loans comes from people who are saving their money for the future if they're worried about the Investments being made they might decide to pull their money out think back to Charles Ponzi and the mob of people he tried to calm down once they heard he was refusing to pay back one of his investors people can get spooked in mass and if they all pull out their money at the same time the supply of loanable funds will collapse and this Market could freeze up gee I wonder if that's ever happened before