The market for loanable funds
A supply-and-demand model of saving and investment, used to see what saving incentives, investment incentives and budget deficits do.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain where the supply of and demand for loanable funds come from
- Find the equilibrium interest rate
- Predict the effects of saving incentives, investment incentives and budget deficits, including crowding out
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 2 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 13
What it is
Mankiw simplifies the whole financial system into a single market for loanable funds, with one interest rate that is both the reward for saving and the cost of borrowing.
- Supply comes from saving. A higher real interest rate makes saving more attractive, so supply slopes upwards.
- Demand comes from investment: firms buying equipment and families buying new homes. A higher interest rate makes borrowing dearer, so demand slopes downwards.
- The interest rate adjusts until saving equals investment. In Mankiw's example, the equilibrium is a 5% interest rate with 1,200 billion dollars of loanable funds.
Quick check
Tap an answer to check it.
The interest rate is below its equilibrium. What happens?
- That happens above the equilibrium
Show answer
Borrowers want more than savers offer, so the rate rises. A shortage of loanable funds pushes the interest rate up.
Why it matters
Mankiw uses the model on three policies, following the three steps from supply and demand.
1. Saving incentives. Tax changes that encourage saving (such as special retirement accounts that shelter saving from tax) shift supply to the right. The interest rate falls and investment rises. In Mankiw's figure the rate falls from 5% to 4%, and loanable funds rise from 1,200 to 1,600 billion.
2. Investment incentives. An investment tax credit, which rewards firms for buying new capital, shifts demand to the right. The interest rate rises and saving rises with it.
3. Government budget deficits. A deficit reduces national saving (public saving is negative), so the supply of loanable funds shifts to the left. The interest rate rises, and private investment falls. This fall in investment caused by government borrowing is called crowding out. In Mankiw's figure, a deficit raises the rate from 5% to 6% and cuts loanable funds from 1,200 to 800 billion.
A budget surplus works the other way: it adds to national saving, lowers the interest rate and encourages investment. Since investment builds capital, deficits that crowd it out can lower long-run growth.
Note that Mankiw treats the deficit as changing supply, not demand: government borrowing reduces the saving available for private borrowers.
Worked example
A loanable-funds market (billions, made up):
| Real rate | Saving | Investment |
|---|---|---|
| 3% | 800 | 1,400 |
| 4% | 1,000 | 1,200 |
| 5% | 1,100 | 1,100 |
| 6% | 1,200 | 1,000 |
- Equilibrium: 5%, with 1,100 lent and invested.
- The government now runs a deficit of 200, so national saving is 200 lower at every rate: 600, 800, 900, 1,000.
- New equilibrium: 6%, where saving (1,000) equals investment (1,000).
- Investment falls from 1,100 to 1,000: 100 of private investment is crowded out.
Text description
The market for loanable funds from the worked example. Saving (supply) rises with the real interest rate; investment (demand) falls with it. They meet at 5% and 1,100. A budget deficit of 200 cuts national saving by 200 at every rate, shifting the saving curve left. The new equilibrium is 6% and 1,000: private investment falls by 100, which is crowding out.
Common mistake
Thinking a budget deficit shifts the demand for loanable funds in this model. In Mankiw's treatment, the deficit lowers national saving, so it shifts supply to the left. The fall in investment is a movement along the demand curve.
Key terms
- market for loanable funds
- the market in which those who want to save supply funds and those who want to invest borrow
- crowding out
- a fall in investment caused by government borrowing
- investment tax credit
- a tax advantage for firms that buy new capital
- budget surplus
- tax revenue greater than government spending
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| market for loanable funds | the market in which those who want to save supply funds and those who want to invest borrow |
| crowding out | a fall in investment caused by government borrowing |
| investment tax credit | a tax advantage for firms that buy new capital |
| budget surplus | tax revenue greater than government spending |
Practice
Work it through
Using the worked example's table without the deficit, saving incentives raise saving by 200 at every interest rate.
- 1,000 + 200
- At 4%, saving (1,200) equals investment (1,200)
- 1,200 − 1,100
Quick quiz
Tap an answer to check it.
An investment tax credit is introduced. What happens to the interest rate and saving?
- That follows a rise in supply, not demand
Show answer
Both rise: demand for loanable funds shifts right. Firms want to borrow more at every rate.
What is crowding out?
- That is a movement along the supply curve
Show answer
A fall in private investment caused by government borrowing. A deficit raises the interest rate, so firms invest less.
In Mankiw's model, which curve does a budget deficit shift?
- Mankiw treats it as a fall in national saving
Show answer
Supply of loanable funds, to the left. Public saving is negative, so national saving falls.
In short
- Supply of loanable funds = saving; demand = investment; the interest rate balances them.
- Saving incentives: lower interest rate, more investment.
- Investment incentives: higher interest rate, more saving.
- Deficits: less national saving, higher interest rate, less investment (crowding out).
Mastery check
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Check yourself
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In Mankiw's example, what is the equilibrium before any policy change?
Show answer
An interest rate of 5% and 1,200 billion dollars of loanable funds.
What does a budget surplus do to the interest rate and investment?
Show answer
It lowers the interest rate and raises investment.
In the worked example, how much investment does the deficit of 200 crowd out?
Show answer
100 (from 1,100 to 1,000).
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 13.
- On this site: Financial markets and intermediaries and Real and nominal interest rates.
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