The Loanable Funds Model and Business Borrowing

The Loanable Funds Model is an economic theory that states business borrowing and lending is determined by the interest rates businesses pay for those loans, and the availability of capital through the banking system and other traditional sources of capital. 

With higher economic liquidity, interest rates decline, and when the inverse occurs, a tighter money supply results. An important question about the loanable funds model is where and how availability of financial liquidity is facilitated as this mechanism determines if an increase in the money supply becomes available to businesses and if it does, at what cost.

Another aspect of the theory of loanable funds is that it may be best perceived in light of the financial dynamic that surround it. For example, according to a report by Anthony J. Makin published by the Australian National University Press, an overabundance of liquidity provided by federal monetary policy financed in part by overseas borrowing may actually have an inverse affect to what was originally intended.

A reason for this financial circumstance is that costs of capital are expensive for the state leading to potential spending cutbacks in infrastructure that fosters growth. Moreover, in this scenario, the demand for more expensive private business financing can actually decline leading to a potential net decline in economic liquidity and growth on top of an increased national cost of debt that in the long-run leads to higher costs for business loanable funds.

In terms of business, the loanable funds model is more likely to have economic benefits if those funds follow their intended purpose, and  the low cost of loanable funds is financed by surpluscapital rather than deficit spending. The reason this may not always happen is that in the case of U.S.banks, money borrowed from the government at cheap interest rates may not necessarily make its way to businesses.

This is because if banks find other opportunities with lower risk for similar or higher returns their borrowed funds are better spent elsewhere. Additionally, as mentioned above, when low cost loanable funds come from deficit spending, it eventually leads to a need for higher interest rates to finance that spending and less consumer and business spending due to a higher cost of capital. So in effect the loanable funds model is somewhat dependent on how and where the capital from loans comes from.

Thus, to summarize, according to the loanable funds model, interest rates in general rise and fall together regardless of their source i.e. government, corporate or private. This is an important correlation to consider because even in times of high cost of capital, private loans are likely to also reflect the rise in risk premium and/or real interest rate. In such case, private loanable funds don't necessarily vanish but come with higher cost, indicating a cost demand relationship and not a supply and demand relationship.

In addition to the above, with the increased cost of loanable funds, comes increased risk and lower availability of many types of business loans. The incorporation of monetary policy, alternate source of capital, inflation and broader economic circumstances into the loanable funds model can have considerable impact on decisions made by businesses and economic outcomes for those businesses.

Sources:

1.http://bit.ly/gRHoRN (Iowa State University)
2.http://bit.ly/eP9qT7  (Australian National University)
3.http://bit.ly/fkXFkE   (Harvey Mudd College)
4.http://bit.ly/dEUeUr (Economy Watch)