Introduction to Finance

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C H A PT E R 8 Interest Rates
Loanable Funds Theory
The 
loanable funds theory
holds that interest rates are a function of the supply of and demand 
for loanable funds. This is a fl ow theory, in that it focuses on the relative supply and demand 
of loanable funds during a specifi ed period. How the supply of and demand for loanable funds 
interact determines both the interest rate and the quantity of funds that fl ow through the fi nancial 
markets during any period. If the supply of funds increases, holding demand constant, interest 
rates will tend to fall. Likewise, an increase in the demand for loans will tend to drive up 
interest rates. This is depicted in Graph B of Figure 8.1.
Sources of Loanable Funds 
Current savings and the expansion of deposits by 
depository institutions represent two basic sources of loanable funds. The Fed, through its 
open-market operations, also provides a source of loanable funds when it purchases govern-
ment securities. 
The supply of savings comes from all sectors of the economy, and most of it fl ows through 
U.S. fi nancial institutions. Individuals may save part of their incomes, either as voluntary 
savings or through contractual savings programs—such as purchasing whole life or endow-
ment insurance policies or repaying installment or mortgage loans. Governmental units and 
nonprofi t institutions sometimes have funds in excess of current expenditures. Corporations 
may have savings available because they are not paying out all their earnings as dividends. 
Depreciation allowances that are not being used currently to buy new capital equipment to 
replace older equipment may also be available for lending.
Pension funds, both governmental and private, provide another source of saving. These 
funds, which are building up large reserves to meet future commitments, are available for 
investment.
Some savings are invested as ownership equity in businesses, either directly in single pro-
prietorships or partnerships or by buying stock in corporations. This is, however, only a small 
part of total savings. The bulk of the total savings each year is available as loanable funds. 
Funds may be loaned directly; for example, when someone lends money to a friend to enable 
him or her to expand business operations. However, most savings are loaned through fi nancial 
institutions, one of whose basic functions is the accumulation of savings.
The second basic source of loanable funds is that created by the banking system. Banks 
and other depository institutions not only channel savings to borrowers, but also create deposits, 
which are the most widely used form of money in the U.S. economy. This process was discussed