Loanable Funds Market vs Money Market

The axis labels are the difference, and they are worth points on their own

These two diagrams are drawn with similar shapes, so graders lean on the labels to tell which model a student is using. The money market has nominal interest rate on the vertical axis, quantity of money on the horizontal, a vertical supply curve because the central bank picks the quantity, and a downward-sloping money demand curve. The loanable funds market has real interest rate on the vertical axis, quantity of loanable funds on the horizontal, an upward-sloping supply curve because higher real returns draw more saving out of income, and a downward-sloping demand curve made up of firms borrowing to invest plus the government when it runs a deficit. Labeling the vertical axis as interest rate with no qualifier is an easy point to lose, and drawing the supply curve with the wrong shape signals the wrong model entirely. Pick the model before drawing anything. If the trigger is the central bank, use the money market. If the trigger is saving, borrowing, or a budget balance, use loanable funds.

A wider deficit crowds out less than a dollar of investment for each dollar borrowed

Put private saving on the supply side and government borrowing into demand alongside private investment, which is the version the exam rewards. Suppose that at a real rate of 4 percent savers supply 90 billion dollars, firms want 60 billion dollars for investment, and the government borrows 30 billion dollars to cover its deficit. Demand of 60 plus 30 matches the 90 billion dollars supplied, so the market clears. The legislature then widens the deficit to 50 billion dollars. At 4 percent, demand would be 110 billion dollars against 90 billion dollars of saving, so the real rate is bid up. Say it settles at 6 percent, where savers supply 100 billion dollars and firms cut planned investment to 50 billion dollars. Demand of 50 plus 50 matches supply again. Private investment fell by 10 billion dollars while government borrowing rose by 20 billion dollars, and the other 10 billion dollars came from saving that the higher return called forth. Crowding out is real and partial, and an answer claiming the deficit displaced an equal amount of investment has forgotten that the supply curve slopes up. Nothing in this story touches the money supply. Students often show a deficit by shifting money supply left, which claims the central bank did something it never did.

Expected inflation moves the nominal rate on both graphs and leaves the real rate where it was

Start with a real rate of 3 percent clearing the loanable funds market while expected inflation runs at 2 percent, so lenders quote 5 percent. Expected inflation then rises to 4 percent. Savers who expect repayment in weaker dollars will not lend at 5 percent any more, and borrowers who expect to repay in weaker dollars will pay more, so supply shifts left, demand shifts right, and the quoted rate settles near 7 percent. Subtract the new 4 percent expectation and the real rate is still 3 percent. One detail matters before you draw it. Textbooks showing this shift relabel the loanable funds axis as the nominal rate first, because curves plotted against the real rate have no reason to move when only expected inflation changes. The money market reaches the same nominal rate by a different route. A higher expected price level means more money is needed for the same basket, so money demand shifts right, and with the money stock fixed the nominal rate is bid up. Notice what neither graph does alone. The money market never displays a real rate, so a question about the real cost of borrowing has to be answered from loanable funds, which is the cleanest test of whether a student is tracking which rate sits on which axis.

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