So the financial system is a wide array of markets, where you can buy stocks, bonds, and all sorts of other investments as well. However, let's simplify the financial system and just say that there's one investment here. There's one product and that's just loanable funds, right? So there's going to be a supply of loanable funds and a demand for loanable funds. Okay? So let's check out this market for loanable funds in this simplified example of the financial system. Obviously, the real financial system has a whole bunch of different products, but if we simplify it here as an introduction, we can kind of see how the supply and demand for loanable funds interact. So when we talk about loanable funds, right? This loanable funds, what is a loanable fund? Well, that's money that can be loaned, right? Money that's available to be either borrowed or loaned out, right? So when we talk about loanable funds, this is income that households have chosen to save rather than spend on consumption, right? So the loanable funds that are available are those savings of the household.
So just like any market, we're going to have supply, demand, we're going to have a price, an equilibrium price and an equilibrium quantity. What are those in this case? When we talk about loanable funds, well just like we said, the supply is those household savings. So when the household saves money, that money is available to be borrowed, right? It's in the bank account and the bank can loan it out to a firm. So the demand is going to be firm's investment. Firm investment is going to be the demand for loanable funds, right? The firms want to borrow money so that they can expand their business, they can buy new machinery, they can build new factories, whatever it might be. That's going to be the demand for loanable funds. And what's going to be the price? What gives you the incentive to save more money? Or what gives the firms a reason to want to demand more funds to borrow? That's going to be the interest rate, right? Think about it. If there was a really high interest rate, you might be incentivized to say, actually I'm going to put more money in the bank because I'm going to get a lot of interest whereas a firm might want a really low interest rate. They want to borrow as cheaply as possible.
So let's go ahead and take this onto the graph. The old graph, our good buddy here, the price quantity graph, right? Our price and quantity. But instead of price in this case, I'm going to change it to interest rate. So the price in this case is the interest rate, that's the price of saving money or borrowing money and when we think about quantity, well that's the quantity of funds available, right? So let's start with the supply, and just like we would expect with a supply curve, the higher the interest rate, the more quantity of funds are going to be available because more people are going to be saving. We would expect that at a low interest rate, something down here, there wouldn't be many funds available, but as we start to increase the interest rate, the funds available are going to increase. Just like we would expect with the supply curve, right? Supply of loanable funds. And what do you think about that demand curve? That double downward demand curve? Well guess what? The same thing follows here. At a high interest rate, we're not going to want to borrow funds as a firm. We're going to say, man, that interest rate is really high. We're not going to be able to make any money. We need to cover that interest. But as that interest gets lower, right? As the interest gets lower, they're going to demand more funds. So at this very low interest rate down here, there's a high demand for these funds but a low supply of the funds.
So what happens? We reach an equilibrium just like we do in any other market. We're going to have this equilibrium right here in the middle, and we're going to have the equilibrium interest rate. I'll say I'll do "r" for rate. \( r^* \) is going to be our equilibrium rate, and then we're going to have our equilibrium quantity \( Q^* \). That's the equilibrium quantity of funds as well. And guess what? Just like with any supply and demand, those curves can shift. There are things that can increase the demand for loanable funds, increasing the supply, right? Those just like we practice with supply and demand, those lines can shift as well. So when we think about, just like what we've discussed, let's go ahead and summarize it here. So the firms compare the rate of return of a new project when they're thinking of making an investment. Hey, I'm going to build this factory. How much money can it make? Oh, well, the investment can make me 10% per year if I build this factory. So should they build the factory? Well, that depends on the rate that they're going to borrow, right? If they can make 10% on their investment, say 10% is right here. And then the rate to borrow is here at 6%. Well, they're going to want to make that investment, right? They're able to make money on the borrowing. They'll only have to pay back 6% interest while they're making 10% at the factory. That would make a sound investment for them, right? So you can imagine, as the equilibrium rate gets lower, well, that gives firms more opportunities to invest, right? So lower rates lead to more investment demand because now at let's say, okay. So in that example, let's say this rate down here 2%, Well now a project that makes 3% looks enticing if there's a project right here. However, at our equilibrium that we've been discussing of 6%, right? You would not want to fund this project because you're going to have to pay 6% interest when you're only making 3%.
Alright? So that's the whole idea of how the demand curve works for the firms here. And just like the households, they have the incentive to save at higher inte
