Loanable Funds Market vs Investment Demand Curve
Loanable Funds Market and Investment Demand Curve are two Financial Sector & Loanable Funds concepts in AP Economics that students often mix up. The loanable funds market is where savers supply funds and borrowers demand funds, and its equilibrium determines the real interest rate. The investment demand curve shows the inverse relationship between the real interest rate and the quantity of investment spending firms want to undertake. Here is how they compare side by side.
The supply comes from private and public saving, while demand comes from borrowers seeking loans for investment. The equilibrium real interest rate balances saving and investment. Shifts in either curve change the interest rate and the quantity of loanable funds.
It slopes downward because a lower real interest rate reduces the cost of borrowing (and the opportunity cost of using funds), making more capital projects profitable, so the quantity of investment demanded rises. A change in the real interest rate causes a movement along the curve, while shift factors, business expectations, technology, taxes on investment, and the existing capital stock, move the whole curve. This curve links the loanable funds market to the investment component of aggregate demand. It explains why expansionary policy that lowers real rates stimulates investment and AD.
Loanable Funds vs the Investment Demand Curve: Two Graphs, Two Jobs
| Loanable Funds Market | Investment Demand Curve | |
|---|---|---|
| What the horizontal axis measures | Quantity of loanable funds borrowed and lent | Quantity of investment spending by firms |
| How many curves you draw | Two, a supply of funds and a demand for funds | One, sloping down to the right |
| What the diagram determines | The equilibrium real interest rate | The investment that goes with a real interest rate you are handed |
| Where a bigger budget deficit appears | As a rightward shift in the demand for funds | Nowhere; the curve stays put and you slide along it |
| What shifts the whole thing | Saving behavior, the government budget balance, inflows of foreign capital | Expected profitability, technology, business confidence, taxes on capital |
| The prompt it answers on an exam | Show what government borrowing does to the real interest rate | Explain why firms cut investment when the real rate rises |
One diagram sets the interest rate, the other reads it off
The two graphs look alike because the real interest rate sits on the vertical axis of both, and that is where the trouble starts. The loanable funds market puts the quantity of funds borrowed and lent on the horizontal axis and draws two curves, so it has an equilibrium and it produces a real interest rate. The investment demand curve puts investment spending on the horizontal axis and draws one curve, so it has no equilibrium of its own. It takes the real interest rate as given and tells you how much investment goes with it. Causation runs one way. Something happens in the loanable funds market, the real rate settles at a new level, and only then do you carry that rate across to the investment demand curve to read off the new quantity of investment. Firms wanting to borrow is what makes the demand for loanable funds slope down in the first place, so the two are relatives, but the demand for funds also counts government borrowing while the investment demand curve does not. A change in expected profitability moves both. A change in the deficit moves only the demand for loanable funds. The module at /macro/loanable-funds walks through the axes and the standard shifts before you try either one under time pressure.
A worked case: crowding out happens on one graph and shows up on the other
Use illustrative numbers, with the real interest rate in percent and quantities in billions of dollars. Suppose the supply of loanable funds is 200 plus 20 times the rate, and private demand is 500 minus 30 times the rate. Setting them equal gives 50 times the rate equal to 300, so the rate is 6 percent and the quantity is 320. Now the government runs a larger deficit and borrows an extra 100, which adds 100 to demand at every rate. The new balance is 200 plus 20 times the rate equal to 600 minus 30 times the rate, so the rate is 8 percent and total lending is 360. Nothing about firms changed, and their curve did not move. Read private borrowing off the original private demand at the new rate of 8 percent and you get 500 minus 240, which is 260. Private investment fell from 320 to 260 while total borrowing rose from 320 to 360. That gap of 60 is the crowding out, and notice where each piece came from: the higher rate came from the loanable funds diagram, and the fall in private investment came from sliding up the investment demand curve. See /glossary/crowding-out for the mechanism written out in full.
Frequently asked questions
Is the investment demand curve the same as the demand for loanable funds?
No, the investment demand curve shows only what firms want to invest at each real interest rate, while the demand for loanable funds adds government and household borrowing on top of that. In the simplest closed economy with no government the two coincide, which is why some textbooks draw them as a single curve.
Which graph shows crowding out?
Both do, in different ways: the loanable funds market shows the higher real interest rate that government borrowing causes, and the investment demand curve shows the fall in private investment that the higher rate produces. A full free-response answer usually needs the loanable funds diagram first, because that is where the rate is determined.
Does the investment demand curve shift when the interest rate changes?
No, a change in the real interest rate moves you along the investment demand curve instead of shifting it. The curve shifts only when something other than the rate changes how much firms want to invest, such as expected sales, a new technology or a change in business taxes.
Live Loanable Funds graph. Drag the curves, or open the full version.
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