Loanable Funds Market

Saving supplies funds, investment demands them, the real interest rate clears the market.

Equilibrium: Q* = 50.0, r* = 5.0

Current equations

S: r = 1 + 0.08·QI: r = 9 − 0.08·Q

Where interest rates come from. Savers supply funds (more when rates are high); investors demand them for projects (more when rates are low). The real interest rate is the price that balances the two. More saving means cheaper borrowing; an investment boom bids rates up.

Shift the curves

Saving supply (thrift, budget surplus)0

More national saving at every interest rate shifts S right; deficits shift it left.

Investment demand (business confidence, tech)0

Better investment prospects raise borrowing demand at every rate. I shifts right.

The Loanable Funds Market model, in writing

Definition

The market where saving (supply of funds) meets investment demand (borrowing), with the real interest rate as the price that clears it.

S(r) = I(r) at equilibrium real interest rate r*

The intuition

Higher rates reward savers but punish borrowers, so the rate settles where the two plans match. A government deficit borrows from the same pool, shifting demand for funds right and raising rates, which squeezes out some private investment: crowding out in one picture.

Exam tip

Label the axis as the REAL interest rate. Crowding out questions want the mechanism spelled out: deficit raises r, higher r reduces private I.

Related models in Money & Finance

Money Market →Baumol-Tobin Money Demand →Capital Asset Pricing Model (CAPM) →Term Structure of Interest Rates →