Loanable Funds Market
What is Loanable Funds Market?
The loanable funds market is where savers supply funds and borrowers demand funds, and its equilibrium determines the real interest rate.
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.
Loanable Funds Market: a worked example
Take supply of loanable funds QS = 300 + 40r and demand QD = 780 - 40r, with quantities in billions of dollars and r as the real interest rate in percent. Setting them equal gives 300 + 40r = 780 - 40r, so 80r = 480 and r = 6 percent. Substituting back, Q = 300 + 40(6) = 540 billion dollars. The government now runs an 80 billion dollar deficit and borrows to cover it, which adds 80 to demand at every rate, so QD' = 860 - 40r. Equilibrium becomes 300 + 40r = 860 - 40r, giving 80r = 560, r = 7 percent, and Q = 580 billion dollars. Total lending rose by 40 billion, but the government took 80 billion of it, so private borrowers get 780 - 40(7) = 500 billion instead of 540 billion. That 40 billion drop is crowding out.
The mistake students make with loanable funds market
Labeling the vertical axis 'nominal interest rate' costs points on loanable funds free response questions. The money market determines the nominal rate, because the opportunity cost of holding cash is the nominal return given up. The loanable funds market determines the real rate, because savers and investors care about purchasing power over the life of the loan. Students blur the two after drawing both graphs in one question. Write 'real interest rate' on the loanable funds axis and 'nominal interest rate' on the money market axis before drawing a single curve.
Loanable Funds Market questions
What shifts the supply of loanable funds?
Supply shifts when the amount households, firms, and foreigners want to save changes at every real interest rate. More private saving, a government surplus adding public saving, or an inflow of foreign financial capital all shift supply right and lower the equilibrium real rate. A drop in saving or capital fleeing abroad shifts it left and raises the rate. Supply is national saving plus net foreign lending, so anything that changes the saving decision rather than the reward for saving belongs here.
Does a government budget deficit raise the real interest rate?
Deficits raise the real interest rate in this model. Government borrowing adds to the demand for loanable funds, demand shifts right, and the equilibrium real rate climbs. Watch the quantity carefully. Total lending actually rises, because the higher rate pulls in extra saving, yet private borrowers end up with less than before once the government takes its share. That squeeze on private investment is crowding out. A surplus runs the other way, lowering the real rate and freeing funds for private borrowers.
What shifts the demand for loanable funds?
Demand shifts when borrowers want a different quantity of funds at every real interest rate. Better expected returns on capital projects, an investment tax credit, optimistic business expectations, or government borrowing to cover a deficit all shift demand right and push the real rate up. Gloomier profit expectations or a government surplus shift it left. A change in the real interest rate by itself moves the economy along the demand curve instead of shifting it, and rubrics test that distinction often.
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
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