To help answer some of these questions, always remember that an interest rate is the price that borrowers pay the lenders to use their funds. Like all market prices, the interest rates are determined and established by supply and demand, in this instant the supply and demand for loanable funds. The supply of loanable funds comes from regular individuals, day to day people that wish to save some part of their incomes in order to consume more in future. For example, some households have high incomes at the present time but expect to earn less in the future after their retirement take place.
The savings they are aiming for, lets them spread their consumption more evenly over time. Also, let's not forget the interest they receive on the money they lend, therefore in the future they can consume more by consuming less now. As a result, the higher the interest rates offered, the greater the incentive to save for the rainy days.
The demands for greater loanable funds have two components. First, some households have the need to consume more than their current incomes allow them too, either because their income are too low now to enjoy the good life but are expected to grow later on, or because they want to make the greater purchase like a house for instance that has to be paid for out of future income.
These individuals are willing to pay interest in return for not having to wait to consume the goods. However, the higher the interest rate will be, the greater the cost of consuming rather than waiting until they can afford it will be, so the less willing these households will be to borrow. The household demand for loanable funds is therefore a declining function of the interest rate.
Normally firms will borrow to invest because the flows of profits from an investment will most of the time come in the future, while the cost of an investment has to be be paid now. Some Firms desires to invest are obviously an important source of demand for loanable funds.
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