The Loanable Funds Market and Crowding Out
Your town wants to build a new bridge and pays for it by borrowing. At the same time, a local bakery wants a loan to buy a new oven. Both are competing for the same pool of savings. What happens to the interest rate the bakery has to pay, and does the bakery still get its oven? By the end of this page you will be able to answer that.
Supply and demand for loanable funds
The loanable funds market is the market where savers lend money and borrowers borrow it. Think of it as one big pool of saving that banks, bond markets, and other financial institutions channel to borrowers.
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Supply comes from savers: households, firms with extra cash, and foreign savers who lend to the US. A higher real rate rewards saving more, so the supply curve slopes upward.
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Demand comes from borrowers: firms that want to invest in factories, equipment, and software, plus households (for example, home buyers) and the government when it runs a deficit. A higher real rate makes borrowing more expensive, so the demand curve slopes downward.
The axes matter. The vertical axis is the real interest rate (not nominal, as in the money market). The horizontal axis is the quantity of loanable funds.
At the equilibrium real rate $r^*$, the amount savers want to lend equals the amount borrowers want to borrow.
In this interactive graph, the horizontal axis (x) is the real interest rate in percent and the vertical axis is the quantity of loanable funds in billions of dollars. Note that it swaps the axes compared with the standard graph above. The rising line is supply and the falling line is demand.
In the loanable funds market, who supplies funds and who demands them? State what is measured on each axis of the graph.
In the loanable funds market, who supplies funds and who demands them? State what is measured on each axis of the graph.
What shifts the curves
Just like in any market, a change in the real interest rate moves you along a curve. Anything else shifts the curve.
| Event | Curve | Direction | Real rate | Quantity |
|---|---|---|---|---|
| Households save more | Supply | Right | Falls | Rises |
| Foreign savers lend more to the US | Supply | Right | Falls | Rises |
| Households save less | Supply | Left | Rises | Falls |
| Firms expect higher profits, want new factories | Demand | Right | Rises | Rises |
| Government borrows more (bigger deficit) | Demand | Right | Rises | Rises |
| Government moves to a surplus | Demand | Left | Falls | Falls |
Why does a surplus shift demand left? A surplus means the government is spending less than it collects, so it borrows less (or even pays off debt). Fewer borrowers means less demand for loanable funds.
The federal government runs a larger budget deficit and borrows more by selling bonds. Which curve in the loanable funds market shifts, and in which direction? What…
The federal government runs a larger budget deficit and borrows more by selling bonds. Which curve in the loanable funds market shifts, and in which direction? What happens to the equilibrium real interest rate?
For each event, state which curve in the loanable funds market shifts, in which direction, and what happens to the equilibrium real interest rate and quantity. (a)…
For each event, state which curve in the loanable funds market shifts, in which direction, and what happens to the equilibrium real interest rate and quantity. (a) Households decide to save more. (b) Firms expect higher future profits and want to build new factories. (c) The federal government moves from a deficit to a surplus. (d) Foreign savers increase their lending to the US.
Government deficits and crowding out
When the federal government spends more than it collects in taxes, it runs a budget deficit and finances it by selling Treasury bonds. Buying a bond means lending to the government, so the government is now a big borrower in the loanable funds market.
Demand shifts right, from $D_1$ to $D_2$. The real rate rises from $r_1$ to $r_2$. Firms now face a higher cost of borrowing, so some investment projects no longer pay off, and private investment falls.
Notice that the quantity of loanable funds rises, but not all of it is private investment. Part of it is the government's borrowing.
Define crowding out. Explain in two sentences how government borrowing can lead to it.
Define crowding out. Explain in two sentences how government borrowing can lead to it.
Before a larger government deficit, the loanable funds market has an equilibrium real interest rate of 4% and a quantity of $\$800…
Before a larger government deficit, the loanable funds market has an equilibrium real interest rate of 4% and a quantity of $\$800$ billion, all of it private investment. After the government borrows an extra $\$100$ billion, the equilibrium real rate is 5% and the equilibrium quantity of loanable funds is $\$850$ billion. Compute private investment after the deficit increase and the amount of crowding out. Explain the mechanism.
Crowding out and fiscal policy
Expansionary fiscal policy (more government spending or lower taxes) raises real GDP through the spending multiplier, $\frac{1}{1 - MPC}$. But if the deficit raises the real interest rate, private investment falls and part of the boost is undone.
How big is crowding out? It depends on the state of the economy:
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Deep recession: Many people and factories are idle, and firms are not eager to invest anyway. Savings are high and borrowing demand is weak, so the real rate hardly moves. Crowding out is small.
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Full employment: Resources are already in use, and borrowers compete hard for funds. The rate rises a lot. Crowding out is large.
The type of spending matters for the long run too. If the borrowed money builds roads, ports, or broadband that raise future productivity, the economy may grow faster later, offsetting the lost private investment. If it funds a tax cut that mostly raises current consumption, there is no such payoff, while the lower investment still reduces the capital stock.
The government increases spending by $\$100…
The government increases spending by $\$100$ billion, and the MPC is 0.8. (a) Compute the change in real GDP using the simple multiplier. (b) The resulting borrowing raises the real interest rate and reduces private investment by $\$40$ billion. Compute the reduction in real GDP due to crowding out, using the same multiplier, and the net change in real GDP. (c) Explain why crowding out weakens the effectiveness of fiscal stimulus.
Compare two uses of a $\$300…
Compare two uses of a $\$300$ billion government deficit: a debt-financed tax cut that mainly raises consumption, and spending on infrastructure that raises future productivity. (a) Explain the effect of each on the loanable funds market. (b) Explain why crowding out is likely to be larger when the economy is at full employment than when it is in a deep recession. (c) Evaluate the long-run effect of each policy on economic growth, and say which one you would favor and why.
Solving with equations
Sometimes the problem gives demand and supply as equations. Set quantity demanded equal to quantity supplied and solve.
In an economy, private demand for loanable funds is $Q_d = 1{,}000 - 100r$ and supply of loanable funds is $Q_s = 200 + 100r$, where $Q$ is in billions of dollars and…
In an economy, private demand for loanable funds is $Q_d = 1{,}000 - 100r$ and supply of loanable funds is $Q_s = 200 + 100r$, where $Q$ is in billions of dollars and $r$ is the real interest rate in percent. (a) Find the equilibrium real interest rate and quantity. (b) The government now borrows an extra $\$100$ billion at every interest rate, so total demand becomes $Qd = 1{,}100 - 100r$. Find the new equilibrium real interest rate and quantity. (c) Compute private investment at the new interest rate and the amount of crowding out. (d) Explain why crowding out is only partial, not complete, in this model.
Back to the start: when the town borrows for its bridge, demand for loanable funds shifts right, the real rate rises, and the bakery may find the oven loan too expensive. That is crowding out. It is partial, because the higher rate also draws out more saving.