The Loanable Funds Market: Study Guide (Macroeconomics 4.7)

What the loanable funds market is

Some people and organisations spend less than they earn. Others want to spend more than they have. The loanable funds market is a model of how the first group lends to the second.

• Savers supply loanable funds. They are households that save part of their income, firms that keep some profit, foreign savers who lend into the country, and the government when it runs a budget surplus.
• Borrowers demand loanable funds. They are mainly firms that want to buy physical capital (machines, factories, software), households that borrow to buy homes, and the government when it runs a budget deficit.

The model joins every kind of lending into one market: bank loans, bonds and other financial assets from Topic 4.1. The “price” of a loan is the real interest rate. The quantity is the amount of funds lent and borrowed in a year.

Why the real rate? Savers want to know how much more they can buy when they are repaid, not just how many more valdas they will get. A firm compares the real return on a new machine with the real cost of the loan. If you need a reminder, real interest rate ≈ nominal interest rate − inflation rate (Topic 4.2).

The demand for loanable funds

The demand curve shows the quantity of funds borrowers want at each real interest rate. It slopes down: a lower real rate means a higher quantity demanded.

The main reason is investment. A firm borrows to buy a machine only if the machine’s expected rate of return is higher than the real interest rate. At a real rate of 8%, only projects that return more than 8% are worth borrowing for. At 3%, many more projects pass the test, so firms borrow more. Households behave in a similar way when they borrow for homes.

The supply of loanable funds

The supply curve shows the quantity of funds savers offer at each real interest rate. It slopes up: a higher real rate means a higher quantity supplied. A higher real rate is a bigger reward for giving up spending today, so households save more and lend more.

A change in the real interest rate causes a movement along a curve. Anything else that changes borrowing or saving shifts a curve.

National saving and investment

The macroeconomic source of loanable funds is national saving. Use these definitions (Y = GDP, C = consumption, T = net taxes, G = government purchases):

• Private saving = Y − T − C (disposable income not spent on consumption)
• Public saving = T − G (the budget surplus; negative when there is a deficit)
• National saving = private saving + public saving = Y − C − G

In a closed economy (no international borrowing or lending), all investment must be financed from national saving, so investment = national saving.

In an open economy, foreign savers can lend into the country and domestic savers can lend abroad. The difference is net capital inflow (inflow minus outflow). Then investment = national saving + net capital inflow. A positive net capital inflow lets a country invest more than it saves.

Worked example 1: national saving in Valdoria

Question. Valdoria is a fictional country; its currency is the valda (VD). In one year: Y = VD 900 billion, C = VD 600 billion, T = VD 180 billion and G = VD 200 billion. (a) Calculate private, public and national saving. (b) Find investment if Valdoria is a closed economy. (c) Find investment if Valdoria is open and has a net capital inflow of VD 25 billion.

(a)

• Private saving = 900 − 180 − 600 = VD 120 billion
• Public saving = 180 − 200 = −VD 20 billion (a budget deficit of VD 20 billion)
• National saving = 120 + (−20) = VD 100 billion

(b) Closed economy: investment = national saving = VD 100 billion.

(c) Open economy: investment = 100 + 25 = VD 125 billion.

Check. National saving also equals Y − C − G = 900 − 600 − 200 = 100. The deficit means the government is a net borrower: it takes VD 20 billion of private saving, so only VD 100 billion of domestic saving is left for investment.

Equilibrium and disequilibrium

Valdoria’s loanable funds market (fictional data, VD billion per year):

Real interest rate	Quantity demanded	Quantity supplied
3%	140	80
4%	120	90
5%	100	100
6%	80	110
7%	60	120

Equilibrium is where quantity demanded equals quantity supplied: a real interest rate of 5% and a quantity of VD 100 billion.

• Below equilibrium (shortage). At 3%, borrowers want 140 but savers offer only 80: a shortage of VD 60 billion. Borrowers compete for scarce funds and lenders can ask for more, so the real rate rises. As it rises, borrowing falls and saving rises until the shortage disappears at 5%.
• Above equilibrium (surplus). At 7%, savers offer 120 but borrowers want only 60: a surplus of VD 60 billion. Lenders cut the rate to find borrowers, so the real rate falls back to 5%.

What shifts the curves

Shifts demand for loanable funds	Shifts supply of loanable funds
Investment incentives, such as an investment tax credit (right)	Saving behaviour: households choose to save more (right) or less (left)
Firms’ expected returns on new capital, for example from new technology (right if they rise)	Public saving: a budget surplus adds funds (right)
Government borrowing to finance a deficit (right)	Net capital inflow from abroad rises (right) or falls (left)

Government spending, taxes and borrowing. Suppose the government raises G or cuts taxes and borrows to cover the larger deficit. There are two sound ways to draw it:

• Demand-side view: the government is an extra borrower, so demand shifts right.
• Supply-side view: the deficit makes public saving more negative, so national saving falls and supply shifts left.

Both raise the equilibrium real interest rate and reduce the amount private borrowers invest. Choose one, label it and stay consistent. A budget surplus works the other way and lowers the real interest rate.

Worked example 2: households save more

Question. A campaign persuades Valdorian households to save more for retirement. At every real interest rate they now supply VD 30 billion more than before. Find the new equilibrium and describe what happens to investment.

Step 1: which curve, which direction? Saving behaviour changed, so supply shifts right by 30 at every rate. Demand does not move.

Step 2: new supply schedule.

Real interest rate	3%	4%	5%	6%
Quantity demanded	140	120	100	80
New quantity supplied	110	120	130	140

Step 3: new equilibrium. Demand equals the new supply at 4% and VD 120 billion.

Step 4: interpret. At the old rate of 5% there is now a surplus of 130 − 100 = 30, so the rate falls. The real interest rate falls from 5% to 4%, and the quantity of loanable funds rises from 100 to 120. At the lower rate, firms borrow more, so investment rises by VD 20 billion. It rises by less than 30 because the lower rate also discourages some saving: a movement down the new supply curve.

Worked example 3: the government borrows more

Question. Valdoria’s government raises spending and finances it by borrowing an extra VD 30 billion at every real interest rate. Start again from the original market (5%, VD 100 billion). Find the new equilibrium and the change in private investment.

Step 1: which curve? Using the demand-side view, the government is a new borrower, so demand shifts right by 30.

Real interest rate	4%	5%	6%	7%
New quantity demanded	150	130	110	90
Quantity supplied	90	100	110	120

Step 2: new equilibrium. 6% and VD 110 billion.

Step 3: who borrows the funds? The government takes 30 of the 110. Private borrowers take the rest: 110 − 30 = VD 80 billion. You can read this from the original demand curve: at 6%, private borrowers want 80. Private investment has fallen from 100 to 80, a fall of VD 20 billion.

Check with the supply-side view. Treat the extra deficit as 30 less national saving at every rate. The supply at 6% would then be 110 − 30 = 80, which equals the original demand at 6%. The real rate is again 6% and private investment is again VD 80 billion. The rate and private investment are the same; only the equilibrium quantity on the graph differs (80, private borrowing, instead of 110, total borrowing).

Common misconceptions

• “Use the nominal interest rate on the vertical axis.” The loanable funds graph uses the real interest rate. The money market (Topic 4.5) uses the nominal rate.
• “A higher interest rate shifts the supply curve right.” A change in the real rate is a movement along the curves. Only other factors shift them.
• “Saving more means less money in the economy, so interest rates rise.” More saving shifts supply right and lowers the real interest rate.
• “Public saving is what the government spends.” Public saving is T − G. A deficit makes it negative.
• “A deficit has no effect if the government borrows from domestic savers.” Its borrowing competes with private borrowers, so the real rate rises and private investment falls.
• “Investment always equals national saving.” Only in a closed economy. In an open economy, add net capital inflow.
• “An investment tax credit increases the supply of loanable funds.” It makes investment more attractive to firms, so it shifts demand right.
• “A shortage pushes the rate down.” A shortage means borrowers want more than savers offer, so the rate is bid up.

Where this leads

This graph is the tool for Unit 5. You will use it in Topic 5.1 to trace policy actions, and later to explain crowding out: how government borrowing can reduce private investment and slow the growth of the capital stock. You will meet capital flows again in Unit 6. If the money market or monetary policy is not yet secure, review Topic 4.6 first.

Try the practice questions now, then use the revision notes and the checklist to consolidate.