Macroeconomics guide, Unit 4, step 14 of 23Previous step Next step

Step 14: The Loanable Funds Market

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Macro 4.7

In 30 seconds

The loanable funds market is where savers lend and borrowers borrow. Its price is the real interest rate.
Supply of loanable funds comes from saving (plus inflows of foreign capital). Demand comes from borrowing, mainly firms borrowing to invest, and the government when it runs a deficit.
A government budget deficit shifts demand right, raises the real interest rate and reduces private investment. This is crowding out.
Do not mix it up with the money market: the money market sets the nominal rate in the short run; the loanable funds market sets the real rate. The link is $ r = i – \pi $.

Video lesson coming soonA short animated lesson for this step will appear here.

What the loanable funds market means

Imagine a town with one big savings pot. Families who spend less than they earn put the difference in through their banks. A café owner wants to borrow for a new coffee machine and a bus company wants three new buses. The pot is limited, so borrowers compete for it. The “price” that balances lending and borrowing is the interest rate.

That imaginary pot is the loanable funds market. In reality it is all the banks and bond markets that move money from savers to borrowers, drawn as one simple supply and demand diagram.

Key termLoanable funds market: a model of the market in which savers supply funds and borrowers demand them, with the real interest rate as the price that brings the two into balance.

The interest rate in this market is the real interest rate. Lenders care what their money will buy. Lend $100 at 7% when prices rise by 3%, and your purchasing power grows by only about 4%. That 4% is the real interest rate.

\[ r = i – \pi \]

Here $ r $ is the real interest rate, $ i $ is the nominal interest rate (the rate written on the loan) and $ \pi $ is the inflation rate. This approximation works well when inflation is low.

Key termReal interest rate: the nominal interest rate minus the inflation rate; it measures the true cost of borrowing and the true reward for saving in terms of goods and services.

Supply and demand: who lends and who borrows

Supply of loanable funds comes from saving. Households save part of their income, firms keep some profits, and a government with a budget surplus adds to national saving. Foreign savers add to supply when they send funds into the country (a capital inflow).

The supply curve slopes upward. A higher real interest rate is a bigger reward for waiting, so people choose to save more.

Demand for loanable funds comes from borrowing. The main borrowers are firms that want to invest in machines, buildings and technology. Households borrow for houses. And when the government spends more than it collects in tax, it must borrow the difference.

The demand curve slopes downward. A firm only borrows for a project if the expected return beats the cost of borrowing. At a 10% real rate, few projects pass that test. At 3%, many more do, so the quantity of funds demanded is larger.

DiagramDraw the vertical axis labelled “Real interest rate (r)” and the horizontal axis labelled “Quantity of loanable funds (Q)”. Draw an upward-sloping supply curve labelled S_LF and a downward-sloping demand curve labelled D_LF. Where they cross, mark the equilibrium real interest rate r₁ and quantity Q₁. Here the amount savers want to lend equals the amount borrowers want to borrow.

Worked example

For example, suppose in a small economy the supply of loanable funds is $ Q_S = 100 + 20r $ and the demand is $ Q_D = 400 – 30r $, where $ Q $ is in billions of dollars and $ r $ is the real interest rate in percent. Find the equilibrium.

Step 1Set supply equal to demand: $ 100 + 20r = 400 – 30r $

Step 2Collect terms: $ 50r = 300 $, so $ r = 6 $

Step 3Substitute back: $ Q = 100 + 20(6) = 220 $. Check with demand: $ 400 – 30(6) = 220 $

The equilibrium real interest rate is 6% and $220 billion is lent and borrowed.

What shifts each curve

A change in the real interest rate moves you along a curve. Something else changing shifts the curve. These are the shifters you need for exams.

Change	Curve that shifts	Real interest rate	Quantity of funds
Households become more thrifty (save more at every rate)	Supply right	Falls	Rises
Households save less (e.g. confidence boom, more spending)	Supply left	Rises	Falls
Capital inflow (foreigners lend more to this country)	Supply right	Falls	Rises
Capital outflow (savers send funds abroad)	Supply left	Rises	Falls
Firms more optimistic, or an investment tax credit	Demand right	Rises	Rises
Firms pessimistic about future sales	Demand left	Falls	Falls
Government budget deficit (more government borrowing)	Demand right	Rises	Rises
Government budget surplus (government adds to saving)	Supply right	Falls	Rises

Common mistakeSome textbooks show a government deficit as a leftward shift of supply (because the deficit reduces national saving) rather than a rightward shift of demand. Both pictures give the same answer: the real interest rate rises and private investment falls. For AP Macroeconomics, the expected convention is that a deficit shifts the demand for loanable funds to the right, and a surplus shifts the supply to the right. Pick one convention and use it consistently in an answer.

Government deficits and crowding out

When a government spends more than it raises in tax, it borrows by selling bonds, competing with firms for the same pool of saving. This pushes the real rate up. At the higher rate, some private projects no longer pay, so firms invest less. Government borrowing has partly “crowded out” private borrowing.

Key termCrowding out: the fall in private investment (and other interest-sensitive spending) caused when government borrowing raises the real interest rate.

DiagramStart from the equilibrium at r₁ and Q₁. The government runs a deficit, so draw a new demand curve D_LF2 to the right of D_LF1. The new equilibrium is further up the supply curve, at a higher real interest rate r₂ and a larger total quantity Q₂. The total quantity rises because the higher rate draws out extra saving, but if you read off the original demand curve at r₂, private borrowing for investment is smaller than before. That gap is the crowding out.

Worked example

Using the same economy as before ($ Q_S = 100 + 20r $, private demand $ Q_D = 400 – 30r $), the government now runs a deficit and borrows an extra $50 billion at every interest rate. Find the new real interest rate, the new level of private investment and the amount crowded out.

Step 1New total demand: $ Q_D = 450 – 30r $. Set equal to supply: $ 100 + 20r = 450 – 30r $, so $ 50r = 350 $ and $ r = 7 $

Step 2Total funds: $ Q = 100 + 20(7) = 240 $. Check: $ 450 – 30(7) = 240 $

Step 3Private investment at 7%: $ 400 – 30(7) = 190 $. Before, it was 220, so $ 220 – 190 = 30 $ is crowded out

The real rate rises from 6% to 7%. Of the $50 billion the government borrows, $30 billion comes from firms investing less and $20 billion comes from extra saving (240 − 220). Private investment falls by $30 billion: that is crowding out.

Why does this matter? Investment builds the capital stock, so less investment today means slower long-run growth. Crowding out is strongest near full employment; in a deep recession, with saving piling up unused, government borrowing pushes rates up very little.

Loanable funds vs the money market

Both graphs have an interest rate on the vertical axis, but they answer different questions.

	Money market	Loanable funds market
Price on vertical axis	Nominal interest rate (i)	Real interest rate (r)
What is traded	Money held as cash and current accounts	Saving lent to borrowers
Supply	Vertical money supply set by the central bank	Upward-sloping: saving plus capital inflows
Demand	Money demand (to buy things, or as an asset)	Borrowing for investment and government deficits
Typical use	Monetary policy in the short run	Fiscal policy, crowding out, saving and long-run growth

The two are linked by $ r = i – \pi $. If the central bank buys bonds and the nominal rate falls in the money market, then with inflation expectations unchanged in the short run, the real rate falls too. A question about a deficit or saving needs the loanable funds graph; a question about the money supply needs the money market.

Worked scenarios

The government cuts taxes and borrows to pay for it. The deficit rises, so demand for loanable funds shifts right. The real interest rate rises and private investment falls (crowding out). In the long run, a smaller capital stock means slower growth.
Foreign investors decide the country is a safe place to lend. Capital flows in, so supply of loanable funds shifts right. The real interest rate falls and the quantity of loanable funds rises, so domestic investment rises.
The government gives firms a tax credit for buying new equipment. Each project becomes more profitable, so firms want to borrow more at every rate. Demand shifts right; the real rate rises and the quantity of loanable funds rises.

Exam tipOn an AP Macroeconomics FRQ, you earn the marks by: labelling the vertical axis “Real interest rate” (not just “interest rate”) and the horizontal axis “Quantity of loanable funds”; showing the shift with a new labelled curve and an arrow; marking the old and new equilibrium rates (r₁, r₂); and then explaining the chain in words: deficit → demand for loanable funds rises → real interest rate rises → private investment falls → slower capital accumulation and long-run growth. In Cambridge 9708 and IB papers, the same chain earns analysis marks, and you add evaluation by saying when crowding out is likely to be small (recession, spare saving, capital inflows).

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A loan has a nominal interest rate of 7% and inflation is 3%. What is the real interest rate? Show worked answer

$ r = i – \pi = 7\% – 3\% = 4\% $.
The lender’s purchasing power grows by about 4% a year.

EasyQ2. Households decide to save a larger share of their income. Using the loanable funds model, what happens to the real interest rate and the quantity of loanable funds? Show worked answer

More saving at every interest rate shifts the supply of loanable funds to the right.
The real interest rate falls and the equilibrium quantity of loanable funds rises. Lower real rates encourage more private investment.

MediumQ3. Supply of loanable funds is $ Q_S = 50 + 25r $ and demand is $ Q_D = 350 – 25r $ (Q in billions, r in percent). Find the equilibrium real interest rate and quantity. Show worked answer

Set $ 50 + 25r = 350 – 25r $.
$ 50r = 300 $, so $ r = 6\% $.
$ Q = 50 + 25(6) = 50 + 150 = 200 $. Check: $ 350 – 25(6) = 350 – 150 = 200 $.
Equilibrium: real interest rate 6%, quantity $200 billion.

MediumQ4. In Q3, the government runs a deficit and borrows an extra $40 billion at every interest rate. Find the new real interest rate and how much private investment is crowded out. Show worked answer

New demand: $ Q_D = 390 – 25r $.
$ 50 + 25r = 390 – 25r $ gives $ 50r = 340 $, so $ r = 6.8\% $.
Total quantity: $ 50 + 25(6.8) = 50 + 170 = 220 $. Check: $ 390 – 170 = 220 $.
Private investment at 6.8%: $ 350 – 25(6.8) = 350 – 170 = 180 $. Before it was 200.
Crowding out = $ 200 – 180 = \$20 $ billion. The other $20 billion of the government’s $40 billion comes from extra saving (220 − 200).

MediumQ5. Explain the difference between the interest rate in the money market and the interest rate in the loanable funds market, and say which graph you would use to show the effect of a budget deficit. Show worked answer

The money market determines the nominal interest rate, with a vertical money supply set by the central bank and a downward-sloping money demand curve. The loanable funds market determines the real interest rate, with saving as supply and borrowing as demand. They are linked by $ r = i – \pi $.
A budget deficit is about government borrowing, so you use the loanable funds graph: demand shifts right and the real interest rate rises.

ExamQ6. Country Z is at full employment and the government increases spending, financed by borrowing. (a) Draw a correctly labelled loanable funds graph and show the effect on the real interest rate. (b) Explain the effect on private investment. (c) Explain the effect on long-run economic growth. [5 marks] Show worked answer

(a) [2 marks] Correctly labelled graph: vertical axis “Real interest rate”, horizontal axis “Quantity of loanable funds”, upward-sloping supply and downward-sloping demand (1). Demand shifts right from D₁ to D₂, and the real interest rate rises from r₁ to r₂ (1).
(b) [2 marks] Private investment falls (1) because the higher real interest rate raises the cost of borrowing, so fewer investment projects are profitable: crowding out (1).
(c) [1 mark] Long-run growth slows, because lower investment means slower growth of the capital stock, so productive capacity (LRAS) grows more slowly.

Check yourself

1. Which of these shifts the supply of loanable funds to the right?

Foreign savers lending into the country add to the supply of funds; the other two raise demand.

2. Under the AP convention, a government budget deficit causes:

The government borrows more, so demand for loanable funds rises and the real interest rate rises.

3. The nominal interest rate is 6% and inflation is 4%. The real interest rate is:

$ r = i – \pi = 6\% – 4\% = 2\% $.

Your score: 0 out of 3

The short version

The loanable funds market matches saving (supply) with borrowing for investment and government deficits (demand). Its price is the real interest rate, $ r = i – \pi $.
More saving, a government surplus or capital inflows shift supply right and lower the real rate; more investment demand or a government deficit shift demand right and raise it.
Government borrowing raises the real interest rate and reduces private investment: crowding out. Less investment means a smaller capital stock and slower long-run growth.
Crowding out is largest near full employment and smallest in a deep recession.
Use the money market for the nominal rate and monetary policy; use loanable funds for the real rate, deficits and saving.