Credit Rationing - Theoretical Background

Theoretical Background

One of the main roles markets play is allocational; they allocate goods to the buyers with the highest valuation. Market equilibrium occurs when the demand of a good at the equilibrium price is equal to the supply of the good. If prices are deemed "too high" by the consumers, supply will exceed demand, and sellers will have to reduce their prices until the market clears (i.e. equilibrium is reached). On the other hand, if prices are "too low", then demand will be higher than supply, and prices will have to be raised to obtain market clearing.

The graph to the right shows this simplified case for the credit market, and is usually referred to as the loanable funds model. The interest rate is denoted by r, and S and I denote savings and investment respectively. This is a highly stylised example, where one abstracts from changes in output, and where the economy is in financial autarky (and, consequently, savings and investment express the supply and demand of loanable funds, respectively).

Equilibrium will be attained at the point where S=I, at the equilibrium interest rate r*. At r>r*, credit is "too expensive", as the interest rate is effectively the price of credit, and there is a resulting excess supply of credit. The interest rate will have to fall in order to clear the market.