The Loanable Funds Market

What Are Loanable Funds?

Now, the Loanable Funds Market… This is how savers and borrowers determine the real interest rate using supply and demand. What are loanable funds? Well, if a family earns $80,000 a year and spends $65,000, that $15,000 left over has to go somewhere—perhaps a savings account, bonds, or a mutual fund. At the same time, a business somewhere might borrow $15,000 to buy a new CNC machine. If you imagine this happening with millions of families and businesses, you've got the loanable funds market. Whenever someone puts a dollar into savings, that dollar is then available for another person to borrow. Households and the government do the saving, and businesses and the government want to borrow for investments and spending.

The real interest rate is what balances these two sides. If the real interest rate goes up, saving is more appealing and borrowing becomes pricier, so people borrow less. Conversely, if it goes down, borrowing is cheaper and saving isn't as rewarding, and borrowing increases. The point where the amount saved is the same as the amount borrowed is where the market finds its balance.

The Supply of Loanable Funds

The supply of funds comes from National Saving, which is all the saving done by individuals and families plus saving done by the government. When people spend less than they make, the extra money goes into the financial system through things like bank accounts, bonds, and other investments.

The supply curve goes upwards - and it's easy to see why. Why lock your money in a CD at only 2% interest? You'd likely just keep it in your checking account. But at 6%, that same person is much more likely to buy a savings bond or a CD that lasts a year. Higher interest rates make it more worthwhile to delay spending.

Government saving is the other part of this. When the government has a budget surplus (takes in more in taxes than it spends) it adds to the pool of money available for lending. A budget deficit does the opposite; the government becomes a borrower itself, using up money that could have gone to businesses for investment. The surpluses during the Clinton years from 1998 to 2001 are a perfect example of the government positively adding to National Saving.

The Demand for Loanable Funds

Most of the demand for these funds comes from businesses, who borrow to buy equipment, build factories, and fund research and development. The government borrows when it has a deficit, but for the AP exam, the focus is on how much businesses want to borrow for investments.

The demand curve goes downwards, and a quick example shows why. A project to expand a factory is expected to make 8% on the investment. If the interest rate is 10%, the business won't go for it because it would lose money. But if the interest rate falls to 5%, that expansion does become profitable.

Economists refer to this as the marginal efficiency of investment. Businesses rank their potential projects by how good their return is - expanding the warehouse at 12%, a new software system at 9%, office renovations at 4%. They borrow for every project that will earn more than the interest rate and ignore the others. Fewer projects are profitable at higher interest rates; more at lower ones.

The real interest rate finds its equilibrium point where supply and demand meet. At this rate, every dollar saved will find someone to borrow it, and every investment project that makes financial sense will get the funding it needs.

Crowding Out

Now imagine the federal government runs an $800 billion deficit in a year. It will need to borrow a lot of money, and that borrowing will use up savings that would have been available to businesses. On a graph, the supply curve shifts to the left. The real interest rate goes up.

Those higher interest rates mean some business investment projects are cancelled. A company planning to borrow for a project that would return 7% won't do it if the interest rate jumps to 8%. This is called crowding out - the government's borrowing pushes private investment out of the way. The larger the deficit, the more severe the crowding out. This was a big worry during the debates about the economic stimulus after 2008, and it has been a common topic on AP free-response questions since.

You can see this on the graph: click "Budget Deficit Up" and watch the interest rate climb and the amount of investment fall.

When government savings plans are made more appealing (like with tax breaks for 401(k)s or larger contribution limits for Roth IRAs) the supply of money available to borrow increases, which lowers interest rates and encourages more investment. Investment tax credits, on the other hand, increase the demand for borrowing, which pushes up the interest rate and then encourages people to save more as they get a better return on their savings.

With an open economy, money to be loaned doesn't stay within a country's borders. If real interest rates in the U.S. are higher than in places like Europe or Japan, money will come from abroad to the U.S., increasing the amount of domestic saving and pushing the interest rate down. Conversely, if U.S. rates fall below those globally, money will leave the U.S. to look for better returns elsewhere. The AP exam sometimes asks if a certain policy will attract or discourage international investment, and students frequently get this direction incorrect.

Connections to Other Models

The loanable funds model is directly related to both government financial policy and the money market. When the government spends more than it receives in taxes (a deficit), interest rates in the U.S. go up. This, in turn, strengthens the dollar in foreign exchange markets because foreign investors want the higher returns from U.S. investments; this makes U.S. goods more expensive for people in other countries and goods from other countries cheaper for Americans. As a result, the amount of net exports (exports minus imports) decreases. In fact, the 2024 AP Macroeconomics free response question specifically examined this relationship: from a deficit, to the interest rate, to the exchange rate, and then to the trade balance.

A very common mistake on the AP exam is confusing the loanable funds market and the money market. The loanable funds market determines the real interest rate (adjusted for inflation), while the money market determines the nominal rate through the Federal Reserve's actions. They're answering different questions by different means, and using information about the Federal Reserve in a problem about loanable funds (or the other way around) will mean you lose points.

A government deficit reduces the amount of loanable funds available by moving the supply curve to the left. It doesn't change the demand. The government is borrowing, and that borrowing is using up savings that would have gone to businesses for investment. This is about supply, not demand. Incorrectly identifying which curve shifts in a free response question will cause you to lose all credit for that part of the problem.

Higher real interest rates attract money from other countries (capital inflows), increasing demand for the domestic currency and making it stronger (appreciation). A stronger dollar makes things made in the U.S. more expensive for people in other countries and things from other countries cheaper for people in the U.S. This lowers net exports. This entire process—interest rates to capital flows, to exchange rates, to net exports—is found in some form on the AP Macroeconomics free response questions nearly every year.