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## AP®︎/College Macroeconomics

### Course: AP®︎/College Macroeconomics>Unit 8

Lesson 2: Every graph used in AP Macroeconomics

# The market for loanable funds model

Understanding and creating graphs are critical skills in macroeconomics. In this article, you’ll get a quick review of the market for loanable funds model, including:
1. what it’s used to illustrate
2. key elements of the model
3. some examples of questions that can be answered using that model.

## What the loanable funds model illustrates

The loanable funds market illustrates the interaction of borrowers and savers in the economy. It is a variation of a market model, but what is being “bought” and “sold” is money that has been saved. Borrowers demand loanable funds and savers supply loanable funds. The market is in equilibrium when the real interest rate has adjusted so that the amount of borrowing is equal to the amount of saving.

## Key Features of the loanable funds model

• A vertical axis labeled “real interest rate” or “r.i.r.” and a horizontal axis labeled “Quantity of loanable funds” or “Q, start subscript, L, F, end subscript
• A downward sloping demand curve labeled D, start subscript, L, F, end subscript and an upward sloping supply curve labeled S, start subscript, L, F, end subscript
• An equilibrium real interest rate and equilibrium quantity labeled on the axis

## Helpful reminders for the loanable funds model

• Use the correct interest rate! The real interest rate is associated with the loanable funds market. The nominal interest rate is associated with the money market.
• Remember that any change in the interest rate that occurs in this model will have a different impact in the short run than in the long run. In the short-run, decreases in the interest rate would cause aggregate demand to increase because there is more
. In the long run, more investment spending will cause the long run aggregate supply curve to increase as well.

## Common uses of the loanable funds model

### Showing the crowding out effect

The crowding out effect occurs when a government runs a budget deficit and, as a result, causes a decrease in private investment spending. When the government borrows money, this results in an increase in the demand for loanable funds, as shown in this graph:

### Showing the impact of a change in saving behavior

All income must be either saved or spent. That means a decrease in consumption will cause an increase in savings. An increase in savings will cause the supply of loanable funds to increase, as shown in this graph:

## Want to join the conversation?

• What exactly is crowding out in terms of graph movements and conceptually?
• Conceptually: crowding out occurs because an increase in interest rates makes private investment more expensive.
Graphically: the shift in the demand for loanable funds results in an increase in the interest rate. The amount of crowding out that occurs is the change in the quantity of loanable funds.
• What would a loanable funds market graph look like in a recessionary/expansionary gap?
• It would look the same, the loanable funds market is meant to show changes and not where an economy is, but rather the effect of a FED change, or consumer changes on interest rates.
• Why is the real interest rate used for the loanable funds model but the real interest rate is used in the money market?