4.7 The Loanable Funds Market

What is the Loanable Funds Market?

The loanable funds market shows how savers (suppliers) and borrowers (demanders) interact through the real interest rate, which acts as the price of borrowing money. Supply of loanable funds comes from savings; demand comes from households, firms, and government borrowing for investment or spending. Equilibrium determines the real interest rate and quantity of funds loaned.

Graphing Supply and Demand

The graph has the real interest rate on the y-axis and quantity of loanable funds on the x-axis. Demand for loanable funds slopes downward (lower rates encourage more borrowing); supply slopes upward (higher rates encourage more saving). Equilibrium is where they intersect, setting the market real interest rate.

Shifters of Supply and Demand

Demand shifters: government budget deficits (increase demand, shift right), investment tax credits, expected profitability. Supply shifters: changes in private saving behavior, national savings rate, or government borrowing/lending. A budget deficit increases demand for loanable funds, raising the real interest rate and causing crowding out of private investment.

Key terms

Loanable funds market

A market where savers supply funds and borrowers demand funds, with the real interest rate as the price.

Supply of loanable funds

Comes from savings; upward-sloping because higher interest rates encourage more saving.

Demand for loanable funds

Comes from borrowers (households, firms, government); downward-sloping because lower interest rates encourage more borrowing.

Crowding out

When government borrowing raises interest rates, reducing private investment spending.

Effect of budget deficit on loanable funds market

Increases demand for loanable funds, shifting demand right and raising the real interest rate.

Try an AP-style question

Government borrowing to finance a deficit shifts…

1. supply of loanable funds right
2. demand for loanable funds right
3. nothing
4. demand for loanable funds left