Topic 4.7 Notes – The Loanable Funds Market

1. The Loanable Funds Market

The loanable funds market shows how savers (suppliers of funds) and borrowers (demanders of funds) determine the real interest rate (r).

• Real interest rate = nominal interest rate adjusted for inflation
• It’s the price of borrowing money in real terms.

Here’s the standard graph you should picture automatically when thinking about this market:

Loanable funds market equilibrium

• Y-axis = real interest rate
• X-axis = quantity of loanable funds
• Demand for loanable funds slopes downward
• Supply of loanable funds slopes upward

The equilibrium real interest rate (often labeled $r_E$ on graphs like this) is where quantity demanded equals quantity supplied.

This model links directly to something you already know:

• Saving = source of funds
• Investment = use of funds
• In a closed economy: S = I

The real interest rate moves until the amount people want to borrow equals the amount people want to save.

2. Demand and Supply of Loanable Funds

Demand for Loanable Funds

Demand comes from:

• Businesses (investment spending on factories, equipment)
• Households (homes, cars)
• Government (budget deficits)

The relationship is inverse:

• Higher $r$ → borrowing is more expensive → quantity demanded falls
• Lower $r$ → borrowing is cheaper → quantity demanded rises

Shifters of Demand

1. Government budget deficits
   • More deficit spending → government borrows more → D shifts right
   • This is what happened after the 2008 financial crisis and during COVID-19 stimulus spending.
2. Business expectations
   • Optimism about future profits → more investment → D right
   • Recession fears → D left
3. Investment incentives
   • Investment tax credit → encourages firms to borrow → D right

When the federal government ran large deficits in the 1980s under Reagan, many economists argued this increased demand for funds and pushed up real interest rates.

Supply of Loanable Funds

Supply comes from:

• Household saving
• Business saving
• Foreign investors
• Banks lending reserves

The relationship is positive:

• Higher $r$ → saving is more rewarding → quantity supplied rises
• Lower $r$ → saving is less attractive → quantity supplied falls

Shifters of Supply

1. Savings behavior
   • Higher saving rate → S right
   • More consumption → S left
2. Government budget position
   • Budget surplus → increases public saving → S right
   • Budget deficit → reduces public saving → S left
3. Foreign capital inflows
   • Foreigners buying U.S. bonds → S right
   • The U.S. often receives large capital inflows because Treasury bonds are seen as safe.
4. Expectations
   • Fear of recession → households save more → S right
   • Expected inflation → people pull money from banks → S left
5. Federal Reserve discount rate
   • Lower discount rate → banks borrow more reserves → S right
   • Higher discount rate → S left

Be careful: the discount rate affects the supply of loanable funds, not demand.

3. National Saving in Closed and Open Economies

Closed Economy

No international borrowing or lending.

$$\text{National Saving} = \text{Private Saving} + \text{Public Saving}$$

• Private saving = income − taxes − consumption
• Public saving = taxes − government spending

If the government runs a budget deficit, public saving is negative.

In a closed economy:

$$S = I$$

All saving becomes domestic investment.

Open Economy

Countries can borrow or lend internationally.

$$I = \text{National Saving} + \text{Net Capital Inflow}$$

• Net capital inflow = foreign money invested domestically
• If domestic saving is low but investment is high, the country borrows from abroad.

The U.S. often runs budget deficits and still maintains strong investment because of foreign purchases of U.S. assets.

4. Equilibrium and Interest Rate Adjustment

Equilibrium

Equilibrium occurs where:

• Quantity demanded = quantity supplied
• This determines equilibrium real interest rate $r^*$ and quantity $Q^*$.

Disequilibrium Adjustment

If $r$ is above equilibrium:

• Quantity supplied > quantity demanded
• Surplus of funds
• Lenders compete → $r$ falls

If $r$ is below equilibrium:

• Quantity demanded > quantity supplied
• Shortage of funds
• Borrowers compete → $r$ rises

The market pushes the real interest rate back to equilibrium automatically.

Effects of Shifts

• Demand ↑ → $r$ ↑, Q ↑
• Demand ↓ → $r$ ↓, Q ↓
• Supply ↑ → $r$ ↓, Q ↑
• Supply ↓ → $r$ ↑, Q ↓

Large government deficits can increase demand, raise real interest rates, and reduce private investment. That reduction in private investment is called crowding out, and it shows up constantly in FRQs.