Do You Understand Financing?

According to the "Loanable Funds" theory, interest is the price paid for the use of "Loanable Funds". It believes that the rate of interest is determined by the equilibrium between supply and demand of "Loanable Funds" in the credit markets. Supplies of "Loanable Funds" are derived from four basic sources...savings, dishoarding, bank credit, and disinvestment.

Savings by individuals or households constitute the most important source of "Loanable Funds". In the "Loanable funds" theory, savings are looked at in one of two ways. One concept is for savings planned by individuals at the beginning of a period in the hope of expected incomes and projected expenditures on consumption, or secondly, consumption of the present period coupled with savings from the preceding period.

Like individuals, businesses also save. A higher rate of interest return is likely to encourage business savings as a substitute for borrowing from the credit markets. This type of savings from business is often used for investment purposes by the firms themselves. This type of savings often Empowers them so they do not enter the market for "Loanable funds".

Dishoarding is another source of "Loanable Funds". Individuals may dishoard money from the hoarded stock of the previous period. Cash balances, lying idle in a previous period become active balances in the present period and are available as "Loanable Funds". At a higher rate of interest return, more cash will be dishoarded. At a lower rate of interest return, the investor tends to hold on to their cash.

The banking system provides a source of "Loanable Funds". By creating credit, banks can advance loans to the businessman. Banks can also reduce the amount of loanable money by contracting their lending. We have seen this dramatically over the last year with the housing market. Banks raised the ante on credit with respect to lending practices, as they were not getting the rate of return they needed to see due to more defaults and contraction within the housing markets. This ante was noticeable in different ways...higher fees, increased interest rates to borrowers, tightening up the guidelines to extend credit, to name just a few. New money created by banks in a period adds greatly to the supply of loan funds. The supply curve of funds provided by banks is directly proportional to the rates of interest return, as has been further noted within the current housing crisis.

"Loanable Funds" and the "Loanable Funds" theory encompass the different scenarios we have discussed. Having a basic understanding of this concept makes it easier to encapsulate concepts surrounding the mortgage industry and how it operates. Education gives you Knowledge...Knowledge is Empowering...