A topic in the Open Knowledge Graph — a free, open map of 15,290 topics and the order to learn them in.
The loanable funds market equilibrates the supply of savings with the demand for investment at a particular real interest rate. An increase in desired savings (from higher income or lower consumption) shifts supply right, lowering rates. An increase in desired investment shifts demand right, raising rates. Government deficits increase the demand for loanable funds, typically raising interest rates and crowding out private investment in the economy.
You know from supply and demand that any market can be understood by identifying who is on each side and what makes the curves shift. The loanable funds market applies exactly that framework to the market for credit. The "good" being bought and sold is not a physical product but loanable funds — money available to be borrowed. The price of this good is the real interest rate: what borrowers pay and savers receive, adjusted for inflation.
The supply of loanable funds comes from savers: households that defer consumption, businesses with retained earnings, and foreign investors lending across borders. Savers supply more funds when the interest rate is higher — a higher return makes saving more attractive relative to spending today. Factors that shift supply include changes in household income (richer households save more), government fiscal surpluses (the government adds to national savings), and capital inflows from abroad. A rightward supply shift lowers the equilibrium real interest rate.
The demand for loanable funds comes from borrowers: businesses seeking to fund investment projects, households borrowing for homes and durable goods, and the government when running deficits. Businesses borrow more when the interest rate is lower — more investment projects clear their hurdle rate when the cost of capital is cheap. Factors that shift demand include changes in investment opportunities (a technology boom raises the expected return to investment, shifting demand right) and government budget deficits (the government must borrow to cover the gap between spending and tax revenue). A rightward demand shift raises the equilibrium real interest rate.
The model delivers a clear and testable prediction about government deficits: when the government borrows heavily, it competes with private borrowers in the same market, pushing up the real interest rate and reducing private investment — the crowding out effect you will examine in the next topic. The loanable funds model is also the macroeconomic counterpart to your microeconomic understanding of how supply and demand determine prices. The interest rate, far from being an arbitrary policy number, is the equilibrium price that coordinates saving and investment decisions across the entire economy. When the Fed adjusts the federal funds rate, it is intervening in this market, shifting supply to push the equilibrium toward a target rate — and the downstream effects on investment, consumption, and output follow from how the market would otherwise have cleared.