9. Modern Portfolio Theory Applied to the Loanable Funds Market

This is another completely new chapter using modern portfolio theory applied to households, firms and commercial banks to fully explain in theoretical terms what happens in the market for loanable funds. Its objective is to analyse the micro foundations of the demand for loanable money as a medium of exchange, store of value and a source of funding within the consumption and production functions and the motives of individual consumers and firms in search of loans. The vital role of the commercial banking system in providing the supply of loanable funds by means of the creation of private money through current accounts within the real economy is modelled by their profit maximisation. It also relates to hedge, speculative and Ponzi borrowers, whether households or firms, (or borrowers with differing levels of risk) and extends the analysis to commercial banks to determine the mark-up that drives the actual level of the rate of interest on borrowing. It shows how that mark-up varies with perceptions of risk (in particular of default on the debts) by commercial banks.