loanable funds
Loanable Funds is the pool of money savers make available and borrowers compete for, with the interest rate acting as the price that matches the two sides.
In plain English
A common mistake many people make is thinking the interest rate on a loan is just a number the bank invents to squeeze customers, so they never bother asking why it moved. Last year it was 18 percent, this year it is 27 percent, and the assumption is that some official in a glass office simply felt like it. That mistake costs people the chance to actually predict where rates are headed next.
Here is what is really happening. Every economy has a pool of money that savers are willing to lend out, made up of people keeping money in fixed deposits, pension funds sitting on contributions, and even foreign investors parking dollars in government bonds. On the other side sits everyone who wants to borrow that pool, a trader in Onitsha needing working capital, a young couple in Lagos wanting a mortgage, the federal government wanting to fund a budget deficit. The interest rate is simply the price that balances how much people want to save against how much people want to borrow.
When the government borrows heavily to plug a budget shortfall, it is drawing from the same pool everyone else is drawing from. More demand for the same funds, without more savings coming in, pushes the price of borrowing up. That is one reason Nigerian lending rates climb when government borrowing rises, quite apart from anything the central bank does with its own policy rate.
A Nigerian in London sending money home is, in a small way, adding to loanable funds back in Nigeria if that money ends up in a Nigerian bank account rather than under a mattress. Multiply that by millions of diaspora transfers and remittances become a real source of supply in that pool, which is partly why economists watch remittance flows so closely.
In the United Kingdom, when the government issues more gilts to cover spending, it is competing with mortgage lenders and business borrowers for the same savings pool, and that tug of war shows up in the rates ordinary borrowers face at their high street bank.
A ₦10,000,000 pool of savings exists in a small market. If government bonds suddenly offer a better return and pull in more of that money, less is left for small business loans, so the bank raises its rate from 20 percent to 24 percent to attract fresh deposits and keep enough in the pool to lend out.
Questions people ask
Who controls the loanable funds market, the central bank or the free market?
Both play a part. The market sets the natural balance between savers and borrowers, but the central bank can nudge things by changing its policy rate, which then ripples through what commercial banks offer savers and charge borrowers.
Why do interest rates rise even when the central bank has not changed its rate?
Because the pool of loanable funds can shift on its own. Heavy government borrowing, a drop in remittances, or savers pulling money out to spend can all tighten the pool and push rates up without any policy announcement.
Does loanable funds theory explain why bank loans are so hard to get in Nigeria?
Partly. If government borrowing and inflation risk are already eating up most of the available pool, banks have less appetite and less cash left to lend to small businesses, which is one reason credit can feel scarce even when banks are technically flush.
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