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 Saving is the source of the supply of
loanable funds.
-For example, when a household
makes a deposit in a bank.
 Investment is the source of the demand of
loanable funds.
-For example, when households take out
mortgages to buy homes. Or, when firms
borrow to buy new capital equipment.
 The interest rate is the price of a loan.
 A high interest rate makes borrowing
more expensive, thus the quantity of
loans demanded falls.
 Similarly, a high rate makes savings
more attractive, and thus increases the
amount of loanable funds supplied.
 If the interest rate were lower than the equilibrium
level, the quantity of loanable funds supplied would
be less than the quantity demanded.
 The result is a shortage of funds, which would
encourage lenders to raise the interest rate, and
thereby increase saving and dissuade borrowing for
 Conversely, if interest rates were higher than
equilibrium, then the quantity of loans supplied
would exceed those demanded.
 As lenders competed for scarce borrowers, interest
rates would be driven down to reach equilibrium.
 Remember, economists distinguish between
nominal and real interest rates.
 The real interest rate is the nominal rate
adjusted for inflation.
 Nominal rate = Real interest rate + Inflation
 Real interest rates more accurately reflect
the real return. Therefore, the supply and
demand for loanable funds depend on the
real interest rate.
Saving Incentives Policy
 American families save a smaller fraction of
their incomes as compared to other
industrialized countries, like Japan and
Germany. (Note: As of 2009, this has
changed somewhat due to the current
recession. National Savings has increased.)
 However, the low savings rate might be due
to tax policies in the U.S. Tax on interest
income reduces incentives to save.
 What if tax incentives were created for
people to shelter some of their savings
income? How would this impact the
market for loanable funds?
 First, which curve would this policy
 Because the tax change would alter the
incentive for households to save at any given
interest rate, it would affect the quantity of
loanable funds supplied at each interest rate.
 Therefore, the supply of funds would shift to
the right.
 As a result, interest rates would be lower,
and investment would increase.
Investment Incentives Policy
 Suppose Congress decides to pass an
investment tax credit to encourage
firms to build new factories.
 As this is investment policy, it would
affect demand. It would change the
demand for loanable funds as firms are
rewarded for borrowing and investing in
new capital.
 Next, since firms would have an
incentive to increase investment at any
interest rate, the demand curve would
shift to the right.
 Interest rates would then rise and the
quantity of loanable funds would
increase. In addition, saving would
increase as well.
Government Budget Deficits
and Surpluses Policies
 A budget deficit is an excess of government
spending over tax revenue.
 Governments finance deficits by borrowing in
the bond market (the accumulation of past
borrowing is our national debt).
 A budget surplus can be used to pay down
some of the debt.
 When spending equals revenue, we have a
balanced budget.
 What would happen if we ran a budget deficit?
 A change in the government budget balance
represents a change in public saving, and, therefore,
in the supply of loanable funds.
 When the government runs a deficit, then we have
negative public savings. Thus, the supply curve
would shift to the left as the supply of the funds
would be reduced.
 This would result in an increased interest rate and
investment would fall.
Crowding Out
 This fall in investment due to the government
borrowing is known as a phenomenon called
“crowding out”.
 Government borrowing crowds out private
 This is one of the risks of expansionary fiscal policy.
 Here’s what the CBO said about the stimulus plan in