Explain why equilibrium in the loanable funds market maximizes efficiency.

The loanable funds market is a theoretical model that represents the financial market, where savers lend their available income to borrowers in the form of loans. In this market, savers supply their funds, while borrowers demand the funds for investment or consumption purposes. The interest rate serves as the price of borrowing these funds.

Equilibrium in the loanable funds market occurs when the quantity of loanable funds supplied equals the quantity of loanable funds demanded at a given interest rate. At this point, the plans of savers and borrowers are compatible, and the market clears with no excess supply or demand for funds. Mathematically, this condition can be written as: Supply of Loanable Funds = Demand for Loanable Funds

Efficiency is achieved in a market when resources are allocated in a way that maximizes social welfare. In the case of the loanable funds market, efficiency is achieved when the funds are allocated to the borrowers who value them the most and are willing to pay the highest interest rate. In other words, there is an optimal allocation of resources where the marginal benefit of lending money equals the marginal cost of borrowing money.

Equilibrium in the loanable funds market maximizes efficiency because at this point, the interest rate reflects the opportunity cost of lending money. In a competitive market, individual borrowers and lenders cannot influence the market interest rate, so they will adjust their plans to match it. When the interest rate is at equilibrium, the quantity of funds that borrowers demand equals the quantity that savers are willing to supply. The borrowers who successfully obtain funds are the ones who value them the most and can put them to the most productive use, as they are willing to pay the market-clearing interest rate. At the same time, savers lend their income to the borrowers who can offer the highest return on their investment. In this way, the equilibrium interest rate allocates funds efficiently, as it directs resources towards their most productive uses, and in turn, maximizes social welfare.