The loanable funds model treats the interest rate as the price that equilibrates saving (supply of funds) and investment (demand for funds). Households and government savings supply funds; businesses borrow to invest. The real interest rate — the nominal rate adjusted for expected inflation — is the relevant variable for economic decisions. Government budget deficits reduce national saving, shifting the supply of loanable funds left, raising real interest rates, and 'crowding out' private investment. This model is a classical view; the Keynesian IS-LM framework embeds a more dynamic treatment.
Draw supply and demand for loanable funds. Then trace the effects of: (1) government deficit increase, (2) increase in consumer confidence, (3) technological boom raising investment returns. In each case identify what shifts and how the equilibrium interest rate changes.
You already know how supply and demand work in a goods market: a price adjusts to equate the quantity supplied with the quantity demanded. The loanable funds model applies the exact same logic to the market for borrowable money. The 'price' in this market is the real interest rate — the nominal rate adjusted for expected inflation. Savers supply funds (the upward-sloping supply curve) because higher rates reward waiting. Borrowers demand funds (the downward-sloping demand curve) because lower rates make investment projects profitable. The equilibrium real interest rate is where these curves cross.
Who are the suppliers and demanders of loanable funds? On the supply side: households save part of their income, and any government surplus adds to national saving. On the demand side: businesses borrow to finance investment in plant, equipment, and inventory; sometimes the government borrows to fund deficits. The supply curve slopes upward because higher rates induce more saving; the demand curve slopes downward because higher rates make fewer investment projects financially viable (a project must earn at least as much as the cost of financing it).
The crowding-out effect is the central policy application of this model. When the government runs a deficit, it must borrow — it enters the loanable funds market on the demand side or, equivalently, reduces national saving (negative public saving offsets private saving). Either way, the supply of loanable funds shrinks, the interest rate rises, and private investment falls. The government is 'crowding out' private investment by competing for the same pool of savings. The size of this effect is contested — it is most pronounced when the economy is at full employment and every dollar the government borrows is a dollar no longer available to businesses.
The real vs. nominal distinction is critical and often confused. The nominal interest rate is the number quoted in loan contracts and savings accounts — it is the rate you see. The real rate is what actually matters for saving and investment decisions, because it measures the purchasing-power return to saving and the purchasing-power cost of borrowing. If inflation is running at 5%, a 7% nominal return is only a 2% real return. Economic decisions — whether to build a factory, whether to save for retirement — depend on real rates, not nominal ones. The loanable funds model is explicitly a model of real interest rate determination.
One important caveat: the loanable funds model assumes the economy is at full employment. In a deep recession, with idle workers and capital, the crowding-out story weakens — government borrowing may draw on resources that would otherwise sit unused, rather than displacing private investment. This is why Keynesian economists, working in the IS-LM framework, give a more nuanced picture of fiscal policy at different stages of the business cycle. The loanable funds model is the right starting point for long-run analysis; the IS-LM model extends it to handle short-run fluctuations.