15.3 Market Rate of Interest

Borrowing and lending are capital transactions. Savings or bank credits are supplied as loanable funds. Borrowers pay the extra charges of interest or discount for the use of loanable funds. Therefore the rate of interest is the price of borrowing loanable funds. Matters like the interest rate being positive, or then how high (or low) an interest should be charged are determined in the same manner like other commodity prices. It is the supply of savings and the demand for loanable funds which together determine the rate of interest. If the number of savers and their amount of saving exceeds the needs of the borrowers then the rate of interest will be relatively low. But if the loanable funds supplied are smaller in size than the needs of the borrowers the rate of interest will be relatively higher. Demand for funds borrowed increases with every fall in the rate of interest. Therefore supply of savings or loanable funds is an upward sloping curve. Demand and supply schedules in the capital market together determine the rate of interest.

In Figure 57 DD is the downward sloping demand curve for loanable funds. The supply curve of loanable funds SS is upward sloping showing an increased savings effort with every rise in the rate of interest. The two curves have intersected at point e which is an equilibrium position in the capital market. At point e the quantity of loanable funds exchanged is L and the rate of interest is r. If the rate of interest is somewhat higher, for instance, like r1, then supply of saving s1 will exceed demand for loanable funds d1 (s1 > d1). Therefore some savers will try to push down the rate of interest and move in the direction of the point e. On the other hand, if the actual rate of interest is lower (r2) then the demand for loanable funds, d2, exceeds supply of savings s2 (d2 > s2). Some of the borrowers will then remain unsatisfied and will try to push the rate of interest upwards by moving in the direction of the point e. Thus r is the only stable equilibrium rate of interest.