The Loanable Funds Market

The loanable funds market sets the real interest rate. It does this through the supply of funds, which includes national saving, both private and public. Then there’s the demand for funds, driven by investments from firms and government borrowing when there's a deficit. This graph is separate from the money market. It answers a different question. Not how much money to hold, but how real saving gets put into real investment.

Supply slopes upward. When the real rate is higher, saving becomes more rewarding, so more funds are supplied. On the other hand, demand slopes downward. A higher real rate means fewer investment projects are profitable, leading to less borrowing.

A government budget deficit cuts national saving. Public saving becomes negative. From the demand perspective, it adds borrowing on top of private investment demand. Either way, demand for loanable funds goes up. This pushes the real rate higher and reduces private investment. This effect is known as crowding out and is now illustrated with its own graph instead of just being explained.

If private saving increases, for instance, through a tax incentive for retirement accounts. The supply shifts right. This lowers the real rate and boosts investment. The opposite effect, sometimes called "crowding in," can also happen.