Page 551 - The Principle of Economics

CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 565
“Whoops! There go those darned interest rates again!”
The demand for loanable funds comes from households and firms who wish to borrow to make investments. This demand includes families taking out mort- gages to buy homes. It also includes firms borrowing to buy new equipment or build factories. In both cases, investment is the source of the demand for loanable funds.
The interest rate is the price of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. Because a high interest rate makes borrowing more expensive, the quantity of loanable funds de- manded falls as the interest rate rises. Similarly, because a high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises. In other words, the demand curve for loanable funds slopes downward, and the supply curve for loanable funds slopes upward.
Figure 25-1 shows the interest rate that balances the supply and demand for loanable funds. In the equilibrium shown, the interest rate is 5 percent, and the quantity of loanable funds demanded and the quantity of loanable funds supplied both equal $1,200 billion. The adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilib- rium level, the quantity of loanable funds supplied would be less than the quan- tity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to raise the interest rate they charge. Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds sup- plied would exceed the quantity of loanable funds demanded. As lenders com- peted for the scarce borrowers, interest rates would be driven down. In this way,