The Loanable Funds Market

You’ll be able to

Identify the supply of and demand for loanable funds and what shifts each
Explain why the real interest rate is the price in this market
Predict the effect of government borrowing on the real interest rate

Saving supplies, investment demands

The loanable funds market brings savers and borrowers together. Supply comes from national saving — private household and business saving plus any government surplus, plus net foreign capital inflows — and slopes upward, since a higher return encourages more saving. Demand comes from borrowers who want to invest: firms financing capital, households financing houses, and governments financing deficits. It slopes downward, since cheaper borrowing makes more projects worthwhile. The price is the real interest rate, because savers and borrowers care about purchasing power.

Axes and shifters

vertical: REAL interest rate · horizontal: quantity of loanable funds · supply shifts: private saving, government surplus, foreign capital inflows · demand shifts: investment demand, government borrowing

The real rate, not the nominal rate. This is the first thing that distinguishes this graph from the money market.

Government borrowing shifts demand

A government deficit must be financed by borrowing, which makes the government a demander of loanable funds. Demand shifts right, the real interest rate rises, and the higher rate discourages private investment. That reduction in private investment is crowding out, and this graph is where the exam expects you to show it. A government surplus does the reverse: it adds to national saving, shifting supply right and lowering the real rate.

Why it matters for growth

Investment is what builds the capital stock, and the capital stock is what shifts LRAS right. So the loanable funds market is the bridge between Unit 4 and long-run growth: policies that raise national saving lower the real interest rate, raise investment, and expand potential output. Policies that absorb saving into government consumption do the opposite. This is the mechanism behind Unit 5's claim that persistent deficits can reduce long-run growth.

Worked example

A government moves from a balanced budget to a large deficit. Show the effect in the loanable funds market on the real interest rate and private investment, and state the consequence for long-run growth.

1.Financing the deficit makes the government a borrower, so demand for loanable funds shifts right.
2.Along the upward-sloping supply curve, the equilibrium real interest rate rises.
3.The higher real rate makes fewer private projects profitable, so private investment falls.
4.Less investment means slower capital accumulation, so LRAS shifts right more slowly.

Answer: Demand shifts right, the real interest rate rises, and private investment is crowded out. The long-run consequence is slower growth in potential output, since capital accumulates more slowly.

Watch out

Government borrowing shifts demand for loanable funds, not supply. A government surplus shifts supply, because it adds to national saving. Mixing these up reverses the effect on the interest rate.

Checkpoint

In the loanable funds market, the variable on the vertical axis is the:

Checkpoint

An increase in household saving shifts which curve, in which direction?

Checkpoint

Crowding out is best shown in the loanable funds market as:

On the exam

When a question involves a deficit, a surplus, or long-run growth, it wants the loanable funds market. When it involves the Fed, open-market operations, or the money supply, it wants the money market. Read for the actor.

Answer the 3 checkpoints as you read.