The Doctrine of Loanable Funds: Can the Fed Create Credit?

The dollar in your pocket loses value every single second. The aggregate loss may be fractional, but there, nonetheless, still is an erosion to your savings. This invariable demarcation occurs as every household’s savings account is beholden to interest rates and, ultimately, inflation. Loanable funds are credit based vehicles created by the Federal Reserve, in part by adopting the principals of fractional reserve banking. That dollar in your pocket has been recirculated many times, with the flow of money, cost to capital, and its value erosion being heavily predicated on the Federal Reserve’s demand for debt, and the inflows imparted by household cash deposits. In essence, the doctrine of loanable funds style the behaviors of consumer burrowing and the net effect it has on our monetary system. Additionally, the doctrine of loanable funds provides a scope to understand better a tactful, yet often quarreled phenomena on how the Fed can create credit out of thin air.


Unlike an imperfect competitive market, where barriers of entry, market share competition and non-homogenous products/service’s influence marketplace prices — the real interest rate, or cost to capital, is based on the premises of having ‘perfect competition within the marketplace.’ Presumably, for perfect competition to exist, several assumptions must be true:

  1. The market for loanable funds is fully integrated, with homogenous products and set prices.
  2. The price to capital (or interest rate) remains consistent.
  3. The assumption is that the price to capital is scalable, according to supply and demand. [Note ‘assumption.’]
  4. The loanable funds’ doctrine applies to the flow of monies over a period of time. A common misconception where ‘govt. revenues generated’ in purview of taxation get mixed up.
  5. The facilitators of credit (financial intermediaries) are expected to create market equilibrium.

The marketplace has two participants: savers, those who provide the cash inflows; and burrowers, those who set the price to capital and realize demand.

  1. Savers- Household savings provide a surplus of present funds. The surplus is defined as income after households pay taxes and pay for consumption. It is not
  2. Burrowers- Those in a deficit, and exist on the demand curve: Firms and governments.

Government revenue is primarily driven by taxes, the supply of money is created by household deposits, and financial institutions facilitate the flow of monies. So as a household depositor, your taxes would be deducted to pay the Governments bills, and then your deposits would be facilitated in the loanable funds market.

The flow of money originates from household deposits, and the Federal Reserve sets its price as an interest rate for the capital sold through the loanable funds market. The trichotomy between household, intermediary, and government reintroduce the capital back to the depositor at a premium price. Essentially- the deposited money is recirculated via the loanable funds market, where the once supplier of cash now becomes the cash consumer. To put it into perspective: when depositors burrow money from the bank, they are — in a sense — buying their own money + someone else money at a premium. Consumer debt, in its purest form is:

(real interest rate + more interest) <= usury law.)

A consumer purchaser of capital is repurchasing — what is essentially our money — at a premium, in assccord to rates set forth by Usary law.

This positions a duality between consumer behavior (demand for loanable funds) and the set price of capital. Pricing dictates consumer trends: when consumers have to pay more money, they will likely purchase less of it. This delves into an inverse relationship that both conventional and unconventional monetary policy could influence. Conventionally, easy money is established after the Fed permits surplus liquidity. The increased cashflows allow the real interest rates to lower somewhat natural sense. Unconventionally though, money is created out of thin air when the Fed adopts policies such as Quantitively Easing. QE is possible when the total amount of credit available exceeds the amount of household deposits within the nation. And with refined financial trickery and a little bit of finesse, financial intuitions and the government position themselves as the creator of credit, thus forming monies out of thin air.

In a transverse sense, the ones who are in demand for money are very ones who could create it too. (We are the consumers of debt, being that we purchase debt instruments at a cost above prime. This premium can range from a few base points from prime lending all the way up to 29.999999999% pending state/local statute.)

Talk about market manipulation! (Wait till you hear about the hidden tax ;o)

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Adel Alaali

Adel Alaali

College Guy, Construction Worker, Curious Mind.