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AP Macroeconomics
The Loanable Funds Market
Loanable Funds Market
• The market where savers and borrowers
exchange funds (QLF) at the r%.
• The D for LF, or borrowing comes from HH, firms, G
and the foreign sector. The D for LF is also the S of
bonds. (people want to borrow or have bonds printed)
• The S of LF, or savings comes from hh, firms, G and
the foreign sector. The supply of LF is also the D for
bonds. (people want to put $ into savings or buy
bonds)
Loanable Funds Market in
Equilibrium
r%
SLF & DBonds
r
DLF & SBonds
q
QLF
Changes in the D for LF
•
•
•
•
Remember that D for LF = borrowing (i.e. S bonds)
More borrowing = more D for LF ()
Less borrowing = less D for LF ()
Examples
– Government deficit spending = more borrowing
= more demand for loanable funds
.: DLF  .: r%↑
– Less investment demand = less borrowing
= less demand for loanable funds
.: DLF .: r%↓
Increase in the Demand
for
Loanable
Funds
r%
SLF
r1
r
DLF
q
q1
DLF  .: r% ↑ & QLF ↑
QLF
DLF 1
Decrease in the Demand
for
Loanable
Funds
r%
SLF
r
r1
DLF 1
q1 q
DLF  .: r% ↓ & QLF ↓
QLF
DLF
Changes in the Supply of
Loanable Funds
•
•
•
•
Remember that S of LF = saving (i.e. D for bonds)
More saving = more S of LF ()
Less saving = less S of LF ()
Examples
– Government budget surplus = more saving
= more supply of loanable funds
.: SLF  .: r%↓
– Decrease in consumers’ MPS = less saving
= less supply of loanable funds
.: SLF .: r%↑
Increase in the Supply
of
Loanable
Funds
r%
SLF
SLF 1
r
r1
DLF
q
q1
SLF  .: r% ↓ & QLF ↑
QLF
Decrease in the Supply of
Loanable
Funds
S
r%
LF 1
SLF
r1
r
DLF
q1
q
SLF  .: r% ↑ & QLF ↓
QLF
Final thoughts on Loanable Funds
• LF market determines the r%
• LF market relates saving and borrowing.
• Changes in saving and borrowing create
changes in LF and .: the r% changes.
• When government does fiscal policy it will affect
the LF market.
• Changes in the r% will affect Gross Private
Investment
•As the r% changes, the quantity of
Investment Demanded changes
•Other determinants that shift the ID curve:
• costs of capital
•business taxes
•Technology
•expectations
r%
(As
compared
to the
expected
rate of
return)
ID
Q
Investment Demand
RIR
S LF
r1
D LF
Q1
•Supply of Loanable Funds:
personal savings and
financial capital from
abroad
•Demand for Loanable Funds:
firms demand for funds for
capital and interest
sensitive consumption
Q
Loanable Funds Market
Effect of Expansionary Fiscal Policy
on Loanable Funds & Investment
SLF
r%
r%
r1
r
DLF 1
ID
DLF
q
q1
QLF
I1
I
G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓
(Crowding-Out Effect)
IG
The Sale/Purchase of Bonds
and the interest rate
If the Fed buys bonds, there is more $ in
the MS and therefore people don’t borrow
and loans become cheap (lower r%)
Buy Bonds = Big Bucks
Sell bonds = small Bucks
The Fed “targets” the Fed Funds Rate by buying & selling bonds. “Buying”
bonds means “bigger” supply of money and lower Fed Funds Rate.
THE CROWDING-OUT EFFECT
• An increase in the government’s deficit shifts
to demand curve for loanable funds to the
right, which leads to a higher interest rate.
• If the interest rate rises, businesses will cut
back on their investment spending.
• So, a rise in the government budget deficit
tends to reduce overall investment spending.
• This negative effect of government budget
deficits on investment spending is called
crowding out.
Loanable Funds Market Graph Recap
(Long-Term Interest Rates)
What changes Demand:
What changes Supply:
1. Increase in Household
1. Increase in
borrowing
Household savings 2. Increase in business
2. Increase in Gov’t
Investment
savings
3. Increase in Foreign
borrowing
3. Increase in Business
4. Increase in Government
savings
borrowing (When the gov’t
4. Increase in
has a budget deficit!) = (the
Foreigners’ savings
crowding -out effect)
Q’s from the AP Exam
1. Using a correctly labeled graph of the
loanable funds market, show the impact of the
increased government spending on the real
interest rate in the economy.
2. How will the real interest rate change affect
the growth rate of the United States economy?
Explain.
Answer
1 points:
• One point is earned for a correctly labeled graph of the loanable funds market.
• One point is earned for showing a rightward shift of the demand curve and
showing a higher real interest rate. (A leftward shift of the supply curve showing a
higher interest rate is also accepted.)
2. 2 points:
• One point is earned for stating that the growth rate will fall.
• One point is earned for explaining that investment spending decreases and, as
a result, capital formation will decrease.
FRQ Practice Q
3. Assume that the real interest rates in both
Canada and India have been 5 percent.
Now the real interest rate in India increases
to 8 percent.
a. Using a correctly labeled graph of the
loanable funds market in Canada, show
how the increase in the real interest rate in
India affects the real interest rate in
Canada.
Canadian Market for Loanable Funds
SLF 1
r%
SLF
r1
r
DLF
q1
q
SLF  .: r% ↑ & QLF ↓
QLF
FRQ Practice Q answer key
b) 2 points:
One point is earned for a correctly labeled
graph of the loanable funds market.
One point is earned for showing a leftward
shift of the supply curve and an increase in
the interest rate.