Money Market or Loanable Funds? Choosing the Graph

You’ll be able to

State the four differences between the money market and the loanable funds market
Select the correct diagram from the wording of a question
Explain why the money supply curve is vertical while loanable funds supply slopes up

Four differences, memorized as a set

They are different graphs answering different questions. Axes: money market has the nominal rate against the quantity of money; loanable funds has the real rate against the quantity of funds. Supply shape: money supply is vertical, set by the central bank; loanable funds supply slopes up, because saving responds to the return. Who shifts it: the Fed shifts money supply; savers and the government budget balance shift loanable funds supply. What it explains: the money market explains monetary policy; loanable funds explains crowding out and long-run growth.

The discriminator

Fed action, money supply, nominal rate → MONEY MARKET · deficit, saving, investment, growth, real rate → LOANABLE FUNDS

Read the question for the actor. The central bank lives in one graph, the government budget in the other.

Why money supply is vertical

The quantity of money is a policy variable. The central bank sets it and it does not respond to the interest rate — a higher rate does not cause the Fed to print more. So the supply curve is a vertical line, and monetary policy is drawn by moving that line. Loanable funds supply is different in kind: it comes from private saving decisions, and people genuinely do save more when the return is higher, which is why it slopes.

Money demand slopes down for a reason worth stating

Money demand slopes downward because the interest rate is the opportunity cost of holding money. Cash in your pocket earns nothing; the same wealth in a bond earns the market rate. When rates are high, holding money is expensive and people economize on it. Money demand shifts with nominal income and the price level — more transactions require more money — which is the link back to AD–AS: a rise in real GDP shifts money demand right and raises the nominal rate.

Worked example

For each, name the correct graph and the shift: (a) the Fed buys bonds; (b) the government runs a large deficit; (c) real GDP rises; (d) households save a larger share of income.

1.(a) The Fed is the actor: money market. Money supply shifts right, nominal rate falls.
2.(b) Government borrowing: loanable funds. Demand shifts right, real rate rises.
3.(c) Higher income raises transaction needs: money market. Money demand shifts right, nominal rate rises.
4.(d) Saving is the source of funds: loanable funds. Supply shifts right, real rate falls.

Answer: Two in each graph. The tell is always the actor — central bank and income changes belong to the money market, budget and saving decisions to loanable funds.

Watch out

Do not draw the money supply curve sloping upward. It is vertical because the central bank sets it, and a sloped money supply implies the Fed responds mechanically to interest rates, which is the opposite of how policy works.

Checkpoint

The money supply curve is drawn vertical because:

Checkpoint

A question asks about the effect of a large federal budget deficit on interest rates and private investment. The appropriate diagram is the:

Checkpoint

Money demand slopes downward because the interest rate represents:

On the exam

Some free responses require both graphs in sequence — the Fed lowers the nominal rate in the money market, and the lower rate raises investment which you then use in AD–AS. Label each diagram separately so the grader can tell which is which.

Answer the 3 checkpoints as you read.