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The market for loanable funds model

Understanding and creating graphs are critical skills in macroeconomics. In this article, you’ll get a quick review of the market for loanable funds model, including:
  1. what it’s used to illustrate
  2. key elements of the model
  3. some examples of questions that can be answered using that model.

What the loanable funds model illustrates

The loanable funds market illustrates the interaction of borrowers and savers in the economy. It is a variation of a market model, but what is being “bought” and “sold” is money that has been saved. Borrowers demand loanable funds and savers supply loanable funds. The market is in equilibrium when the real interest rate has adjusted so that the amount of borrowing is equal to the amount of saving.

Key Features of the loanable funds model

  • A vertical axis labeled “real interest rate” or “r.i.r.” and a horizontal axis labeled “Quantity of loanable funds” or “QLF
  • A downward sloping demand curve labeled DLF and an upward sloping supply curve labeled SLF
  • An equilibrium real interest rate and equilibrium quantity labeled on the axis

Helpful reminders for the loanable funds model

  • Use the correct interest rate! The real interest rate is associated with the loanable funds market. The nominal interest rate is associated with the money market.
  • Remember that any change in the interest rate that occurs in this model will have a different impact in the short run than in the long run. In the short-run, decreases in the interest rate would cause aggregate demand to increase because there is more
    . In the long run, more investment spending will cause the long run aggregate supply curve to increase as well.

Common uses of the loanable funds model

Showing the crowding out effect

The crowding out effect occurs when a government runs a budget deficit and, as a result, causes a decrease in private investment spending. When the government borrows money, this results in an increase in the demand for loanable funds, as shown in this graph:
An increase in the demand for loanable funds caused by a budget deficit, which leads to an increase in the real interest rate.

Showing the impact of a change in saving behavior

All income must be either saved or spent. That means a decrease in consumption will cause an increase in savings. An increase in savings will cause the supply of loanable funds to increase, as shown in this graph:

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