The market of loanable funds:
The market for loanable funds shows the interaction between borrowers and lenders that helps determine the market interest rate and the quantity of loanable funds exchanged.
The market for loanable funds consists of two actors, those loaning the money (savings from households like us) and those borrowing the money (firms who seek to invest the money). Those loaning the money are the suppliers of loanable funds, and would like to see a higher return on their savings. This means that higher interest rates are going to motivate people to either start saving, or save more. This is why there is a positive relationship (upward trend) between the loanable funds and the real interest rate for the supply of loanable funds curve.
The second curve represents those borrowing loanable funds and is called the demand for loanable funds line. People who are interested in borrowing money are more likely to do so if the opportunity cost of borrowing money is low (meaning a low real interest rate). Another way to think of it is to analyze how good the return on an investment will be. If the return on your investment is 5% and the interest rate is 6%, then you won’t borrow the money. However, if your return rises to 7% then now you will make money on the deal because you are making 7% and only paying 6% to borrow the money. This is why more people will demand loanable funds the lower the real interest rate gets.
You can see in the above graph that the supply of loanable funds and the demand of loanable funds cross and give us an equilibrium interest rate of I* and an equilibrium quantity of loanable funds at Q*.
Crowding out in the loanable funds market:
Let’s say that the government decides to increase government purchases, which will increase the demand for loanable funds. This will shift the demand curve right, resulting in a higher interest rate and a higher quantity of loanable funds. The magnitude of the shift right is the increase in the amount of government purchases a movement from Q* to Q’ (if all of it is borrowed). The difference between the new Q’’ and Q’ shows much private investment is crowded out due to the idea of crowding out theory (that firms invest less when the government runs a deficit).