AP® Macroeconomics · Unit 4 · Topic 4.7
The Loanable Funds Market
The loanable funds market is where savers' funds meet borrowers' demand for investment, and the real interest rate adjusts until the quantity saved equals the quantity invested.
Savers and borrowers don't meet in person, so they need a price to coordinate: that price is the real interest rate. Savers are the supply side, households and firms who give up current spending to lend funds, and they supply more as the rate rises because saving pays off better. Borrowers are the demand side, firms wanting to finance investment projects, and they demand less as the rate rises because borrowing gets more expensive. The real rate is what matters here because it measures the true return after stripping out inflation, which is what savers and investors actually care about.
The market clears the way any market does: at the equilibrium real rate, the quantity of funds supplied by savers equals the quantity demanded by investors. If the rate is too high, saving exceeds investment, and the surplus of funds pushes the rate down. If the rate is too low, investment demand exceeds saving, and the shortage pushes the rate up. Graphically this looks just like a supply and demand diagram, with saving as an upward-sloping supply curve and investment as a downward-sloping demand curve, crossing at equilibrium.
It's easy to confuse this with the money market because both put an interest rate on the vertical axis, but they are different markets answering different questions. The money market sets the nominal interest rate by matching the demand for money against a money supply controlled by the central bank. The loanable funds market sets the real interest rate by matching national saving against investment demand, with no central bank supply curve involved. Changes in loanable funds show up later as shifts in investment spending in the real economy.
Key terms
- Loanable funds market
- The market where the supply of saving meets the demand for investment, determining the real interest rate.
- Real interest rate
- The interest rate adjusted for inflation, representing the true cost of borrowing or return on saving.
- National saving
- The total saving in an economy available to be lent out, forming the supply curve for loanable funds.
- Investment demand
- Firms' desire to borrow funds for capital projects, forming the downward-sloping demand curve for loanable funds.
- Crowding out
- A fall in private investment caused by higher real interest rates, often from increased government borrowing.
Watch it explained
- How it worksHow does the real interest rate move to clear the market for loanable funds?
- Common mistakeWhy isn't the loanable funds market the same graph as the money market?
- Worked exampleFind the equilibrium real rate when saving is S = 200 + 20r and investment is I = 500 - 30r.
- Going furtherWhat happens to the real interest rate when a country opens itself up to foreign savers?
Check yourself
End of topic.