Loanable Funds
Saving, investment, real interest rates, and crowding out.
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What this graph shows
The loanable funds market shows how saving and borrowing determine the real interest rate over the long run. The supply of loanable funds comes from saving and slopes upward, since a higher real rate rewards savers and increases the funds available to lend. The demand comes from firms and governments that borrow for investment, and it slopes downward because a higher real rate makes projects more expensive to finance.
The equilibrium real interest rate sits where saving supply meets investment demand. Preset shocks let you run a budget deficit that crowds out investment, a surplus that adds to saving, an investment tax credit that raises borrowing demand, or saving incentives that raise supply. This is how AP Macro explains crowding out and the long-run effects of government borrowing.
How to read it
The horizontal axis is the quantity of loanable funds and the vertical axis is the real interest rate, not the nominal rate. Supply, driven by saving, slopes up, and demand, driven by investment, slopes down. Equilibrium is the intersection labeled r*, where the amount saved equals the amount borrowed. A rightward supply shift or a leftward demand shift lowers the real rate, while a leftward supply shift, such as government deficit borrowing, raises the real rate and crowds out private investment.
Three things to try
- Apply the Budget Deficit shock and watch supply shift left. The real interest rate rises and the quantity of funds falls, the textbook picture of government borrowing crowding out private investment.
- Apply the Saving Incentives shock to shift supply right. The real interest rate falls and more funds are borrowed, showing how higher national saving cheapens investment.
- Apply the Investment Tax Credit shock to shift demand right. The real interest rate rises because firms compete for a limited pool of savings, distinct from a supply-driven rate change.
Common questions
Does the loanable funds market use the real or nominal interest rate?
It uses the real interest rate, which is the nominal rate adjusted for inflation. That is what matters for long-run saving and investment decisions, and it is why the vertical axis here differs from the money market, which uses the nominal rate.
What is crowding out in the loanable funds market?
Crowding out happens when government deficit borrowing reduces the supply of loanable funds available to private borrowers. The real interest rate rises, which discourages private investment, so government borrowing partly displaces business investment.
What shifts the demand for loanable funds?
Demand for loanable funds shifts when the desire to borrow for investment changes. An investment tax credit, new business opportunities, or expected higher returns shift demand right and raise the real interest rate, while weaker investment prospects shift it left.
Loanable Funds: key terms
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