- Loanable funds theory
- Loanable funds theory says the interest rate is set where the supply of savings available to lend equals the demand for loans from households, firms and government.
- Liquidity preference theory
- Liquidity preference theory says the interest rate is set where the demand to hold wealth as money equals the money supply set by the central bank.
What shifts the market for loanable funds
Can you name four things that shift the supply of or the demand for loanable funds?
Each moves a whole curve, and with it the interest rate.
Income sets how much households can put aside: when incomes rise they save more, and the supply of loanable funds shifts right.
Can you think of an example?
A pay rise lets a household save £200 a month instead of £100, adding to what banks can lend.
Borrowers' confidence is how sure households and firms are that they can repay: more confidence shifts the demand for loanable funds right.
Can you think of an example?
In a boom firms expect new equipment to pay well and borrow more at every rate; in a recession they borrow less.
Government borrowing to cover a budget deficit adds to the demand for loanable funds at every interest rate.
Can you think of an example?
The government sells more gilts to cover a larger deficit, competing with firms for the same savings.
Central bank action changes the reserves banks have to lend: an expansionary monetary policy shifts the supply of loanable funds right.
Can you think of an example?
The Bank of England buys gilts, adding to the reserves banks hold, and market interest rates fall.