Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- The loanable funds market models savers lending to borrowers. Its price is the real interest rate.
- Demand (borrowers: firms investing, households, a government in deficit) slopes down: at a lower real rate more investment projects are worth funding.
- Supply (savers: households, firms, foreign lenders, a government in surplus) slopes up: a higher real rate rewards saving.
- Equilibrium: the real rate at which quantity demanded equals quantity supplied.
- Below equilibrium there is a shortage and the rate rises; above it there is a surplus and the rate falls.
Key relationships
| Relationship | Formula or result |
|---|---|
| Private saving | Y − T − C |
| Public saving | T − G (negative in a deficit) |
| National saving | private + public = Y − C − G |
| Closed economy | investment = national saving |
| Open economy | investment = national saving + net capital inflow |
| Investment tax credit | demand right → real rate up, quantity up |
| Households save more | supply right → real rate down, quantity up |
| More government borrowing | demand right (or supply left) → real rate up, private investment down |
| Net capital inflow rises | supply right → real rate down, quantity up |
Assumptions
- All kinds of lending (loans, bonds) are combined into one market.
- Amounts are flows per year.
- A change in the real rate moves you along a curve; other factors shift it.
- A government deficit can be shown as a demand shift or a supply shift. Both give a higher real rate.
Mistakes to avoid
- Labelling the vertical axis “interest rate” or “nominal interest rate” instead of real interest rate.
- Confusing this graph with the money market, where supply is vertical.
- Shifting supply for an investment tax credit. It shifts demand.
- Saying more saving raises the interest rate. It lowers it.
- Writing public saving as G − T.
- Forgetting net capital inflow in an open economy.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide. Amounts are in VD billion.
- Y = 400, C = 290, T = 60, G = 75. What are private, public and national saving? (50, −15, 35)
- National saving is 120 and net capital inflow is 15. What is investment in this open economy? (135)
- A new technology raises the expected return on new machines. Which curve shifts, and what happens to the real interest rate? (Demand right; the real rate rises.)
Next: practice questions.