AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/4/4-7)
Unit 4 · Topic 4.7
4.7 The Loanable Funds Market
The loanable funds market brings together savers, who supply funds, and borrowers, who demand them, and it sets the real interest rate. Changes in saving, investment plans or government borrowing shift the curves and change that rate. You'll use this graph again for crowding out and international capital flows.
Key terms
- loanable funds market
- real interest rate
- national savings (public + private)
- supply of loanable funds
- demand for loanable funds
- investment tax credit
Drawing the loanable funds market
Label the graph as listed below. Equilibrium is where the two curves cross, at r1. If the real rate is above r1, more funds are offered than borrowers want (a surplus), and lenders compete by offering lower rates. Below r1, borrowers want more than savers offer (a shortage), and the rate gets bid up.
- Vertical axis: real interest rate.
- Horizontal axis: quantity of loanable funds.
- Demand for loanable funds (DLF): slopes downward. Borrowers, mostly firms planning investment, borrow more when the real interest rate is lower, because more projects pay off.
- Supply of loanable funds (SLF): slopes upward. Savers lend more when the real interest rate is higher, because saving pays more.
- Equilibrium: where SLF crosses DLF, at real interest rate r1 and quantity Q1.
Where the funds come from: national saving
In a closed economy, one with no borrowing from or lending to other countries, the supply of loanable funds comes from national saving. National saving has two parts, listed below. In the formulas, Y is income, C is consumption, G is government spending and T means taxes minus transfer payments.
In an open economy, funds also cross borders. Then investment = national saving + net capital inflow. A country that saves little can still invest a lot if foreign savers send it funds (6.6).
- Private saving: what households don't spend on consumption or pay in taxes. Private saving = Y − T − C (income − taxes − consumption).
- Public saving: the government's budget balance. Public saving = T − G (taxes − government spending). A surplus adds to saving; a deficit makes public saving negative.
- National saving = private saving + public saving.
What shifts the curves
The table shows the usual way to draw each change. A government deficit can also be shown as SLF shifting left, because the deficit lowers public saving. Either way, the real interest rate rises. Both methods are used in textbooks and accepted in AP scoring (5.5).
| Change | Curve that shifts | Real interest rate | Quantity of loanable funds |
|---|---|---|---|
| Households save more | SLF shifts right | Falls | Rises |
| Households save less | SLF shifts left | Rises | Falls |
| Tax break on interest earned from saving | SLF shifts right | Falls | Rises |
| Investment tax credit, or firms more optimistic about profits | DLF shifts right | Rises | Rises |
| Government borrows more to cover a deficit | DLF shifts right | Rises | Rises |
| Capital flows in from abroad | SLF shifts right | Falls | Rises |
Money market or loanable funds?
Both graphs have an interest rate on the vertical axis, but they answer different questions. Use the money market for central bank actions in a limited-reserves system. Use loanable funds when the question is about saving, government borrowing, investment incentives or international capital flows.
| Feature | Money market | Loanable funds market |
|---|---|---|
| Interest rate on the vertical axis | Nominal | Real |
| Supply curve | Vertical, set by the central bank | Upward-sloping, from savers |
| Demand curve | People who want to hold money | Borrowers, mostly for investment |
| Typical uses | Monetary policy with limited reserves | Deficits, crowding out, saving and capital flows |
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Calculating national saving
In a closed economy, income is $1,000 billion, consumption is $700 billion, taxes minus transfers are $200 billion and government spending is $250 billion. (a) Find private saving, public saving and national saving. (b) Suppose instead the economy is open and has a net capital inflow of $30 billion. How much investment can it fund?
Show the solutionHide the solution
- Step 1: (a) Private saving = Y − T − C = 1,000 − 200 − 700 = $100 billion.
- Step 2: Public saving = T − G = 200 − 250 = −$50 billion. The government runs a $50 billion deficit.
- Step 3: National saving = 100 + (−50) = $50 billion.
- Step 4: (b) Investment = national saving + net capital inflow = 50 + 30 = $80 billion.
Answer: (a) Private saving $100 billion, public saving −$50 billion, national saving $50 billion. (b) $80 billion of investment.
- Example 2
An investment tax credit
The government offers firms an investment tax credit. Show the effect on the loanable funds market.
Show the solutionHide the solution
- Step 1: Draw the market: real interest rate on the vertical axis, quantity of loanable funds on the horizontal axis, DLF1 sloping down and SLF sloping up, crossing at r1 and Q1.
- Step 2: The tax credit makes investment projects more profitable at every real interest rate, so firms want to borrow more. DLF shifts right from DLF1 to DLF2.
- Step 3: Saving behavior hasn't changed, so SLF stays put.
- Step 4: The new equilibrium has a higher real interest rate (r2) and a larger quantity of loanable funds (Q2).
Answer: DLF shifts right; the real interest rate rises from r1 to r2 and the quantity of loanable funds rises from Q1 to Q2.
- Example 3
Saving more (classic trap)
Households decide to save a larger share of their income. A student shifts DLF to the left, reasoning that 'people are borrowing less.' What's the correct analysis?
Show the solutionHide the solution
- Step 1: Saving is the supply side of this market. Households that save more are offering more funds to lend.
- Step 2: So SLF shifts right. DLF doesn't shift, because firms' borrowing plans haven't changed.
- Step 3: The real interest rate falls. Along the unchanged DLF, firms borrow and invest more at the lower rate, so the quantity of loanable funds rises.
Answer: SLF shifts right, the real interest rate falls, and the quantity of loanable funds (and investment) rises.
Common mistakes
- Labeling the vertical axis 'nominal interest rate'. The loanable funds market uses the real interest rate.
- Shifting DLF when saving changes. Changes in saving shift supply; changes in borrowing and investment plans shift demand.
- Treating a government deficit as positive public saving. A deficit makes public saving negative, which lowers national saving.
- Drawing a vertical supply curve. Only the money market has a vertical supply curve; SLF slopes upward.
On the exam
- Free-response questions often ask for a correctly labeled loanable funds graph showing a deficit, a change in saving or an investment tax credit, and then ask what happens to the real interest rate and investment.
- Long questions frequently link this graph to others: a higher real interest rate can reduce investment (5.5), slow growth in the capital stock (5.6) and attract capital inflows that raise the currency's value (6.6).
Connected topics
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Check yourself
4 questions on 4.7 The Loanable Funds Market. Pick an answer to see if you got it, and why.
Country Q's loanable funds market is drawn with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis.
The supply of loanable funds (SLF) slopes upward and the demand for loanable funds (DLF) slopes downward. They cross at a real interest rate (r1) of 4 percent and a quantity (Q1) of $500 billion.
Hypothetical scenario
Country Q's government increases its budget deficit and borrows to cover it. Showing this as a change in demand, which of the following describes the effect on the loanable funds market?
Suppose instead households in Country Q decide to save a larger share of their incomes. Which of the following describes the effect?
Suppose instead Country Q passes an investment tax credit that cuts taxes for firms that buy new equipment. Which of the following best describes the effect on the loanable funds market?
Suppose instead firms in Country Q become pessimistic about future sales and cut their investment plans. What happens to the real interest rate and the quantity of loanable funds?
0 of 4 answered