AP Syllabus focus: ‘Government spending, taxes, borrowing, investment tax credits, and changes in saving behavior shift loanable funds demand or supply.’
These notes explain how policy and behavioural changes shift the loanable funds supply and demand curves, changing the real interest rate and the equilibrium quantity of funds available for borrowing and lending.
Core idea: what shifts the curves?
In the loanable funds market, the real interest rate adjusts to balance funds supplied (saving) and funds demanded (borrowing for investment and other uses).
Equilibrium in the loanable funds market occurs where the supply of saving intersects the demand for borrowing. The diagram shows how the equilibrium real interest rate and equilibrium quantity of loanable funds are jointly determined by this intersection, providing the baseline for analyzing later curve shifts. Source
This subtopic focuses on shifters (not movements along the curves).
Two key channels
Government fiscal actions change national saving, shifting the supply of loanable funds.
Policies affecting investment profitability change desired borrowing for capital, shifting the demand for loanable funds.
Government spending, taxes, and borrowing (supply-side shifters)
When the government changes spending (G) or tax revenue (T), it changes the government budget balance and therefore public saving, which is part of national saving and the supply of loanable funds.
= net tax revenue collected by the government (dollars)
= government purchases of goods and services (dollars)
A higher budget deficit means less public saving, reducing national saving and shifting loanable funds supply left.
Budget deficit: A situation where government spending exceeds tax revenue in a given period (i.e., ), typically financed by borrowing.
How specific fiscal changes shift supply
Increase in government spending (G) with taxes unchanged
Public saving falls (or deficit rises)
Supply of loanable funds shifts left
Real interest rate tends to rise; equilibrium quantity of loanable funds tends to fall
Tax cut (lower T) with spending unchanged
Public saving falls
Supply shifts left (same direction as higher G)
Tax increase (higher T) or spending cut (lower G)
Public saving rises
Supply shifts right
Real interest rate tends to fall; equilibrium quantity tends to rise
Government borrowing: the mechanism students should articulate
Government borrowing to finance a deficit does not directly “move” the supply curve; it is the reduction in national saving that shifts supply left. In standard AP framing, deficit spending can raise the real interest rate and reduce private investment.
This crowding-out diagram shows the supply of loanable funds shifting left (from reduced national saving), which raises the equilibrium real interest rate and reduces the equilibrium quantity of funds lent and borrowed. The horizontal gap highlights the reduction in funds available for private investment when government deficits absorb saving. Source
Crowding out: When higher government deficits reduce national saving, raising the real interest rate and decreasing private investment spending.
Investment tax credits (demand-side shifters)
An investment tax credit raises the after-tax return to firms from buying capital (machines, structures, technology). That increases desired investment at every real interest rate, so it shifts demand for loanable funds right.
Demand shifts from investment incentives
Investment tax credit introduced or expanded
Firms’ expected after-tax profitability rises
Demand for loanable funds shifts right
Real interest rate tends to rise; equilibrium quantity tends to rise
Investment tax credit reduced or removed
Demand shifts left
Real interest rate tends to fall; equilibrium quantity tends to fall
Changes in saving behaviour (supply-side shifters)
Households and firms may change saving because of preferences, uncertainty, wealth, or expectations about future income. These changes affect national saving and thus the supply of loanable funds.
Common behavioural shifters
Increase in desired saving (more thrift, precautionary saving)
Supply shifts right
Downward pressure on the real interest rate; more funds available for borrowing
Decrease in desired saving (higher consumption preference)
Supply shifts left
Upward pressure on the real interest rate; fewer funds available
What to say in a graph-based explanation
Identify the policy/behaviour change
State which curve shifts (supply or demand) and direction
State the predicted change in:
Real interest rate (up or down)
Equilibrium quantity of loanable funds (up or down)
If relevant, connect to private investment via crowding out or increased investment incentives
FAQ
If supply shifts left and demand shifts right, both changes raise the real interest rate, but they move quantity in opposite directions.
Quantity rises if the demand increase dominates.
Quantity falls if the supply decrease dominates.
They can, but indirectly.
Transfers may reduce private saving (recipients spend more) and can increase deficits, both of which can reduce national saving and shift supply left, depending on how they’re financed.
If households expect higher future taxes to pay for deficits, they may increase saving now.
That behavioural response could partially offset a leftward supply shift from a current deficit, though the offset is typically incomplete.
Key factors include:
Responsiveness of saving to the real interest rate (supply elasticity)
Responsiveness of investment to incentives (demand elasticity)
Availability of alternative financing sources
More elastic supply tends to produce a bigger quantity increase and a smaller interest-rate rise.
Crowding out is weaker when private saving rises substantially, when investment demand is weak, or when ample global saving finances domestic borrowing.
In such cases, the supply reduction faced by domestic borrowers may be smaller than expected.
Practice Questions
(2 marks) Explain how an increase in government borrowing to finance a budget deficit affects the loanable funds market and the real interest rate.
1 mark: Supply of loanable funds shifts left due to lower national/public saving.
1 mark: Real interest rate rises (equilibrium interest rate increases).
(6 marks) A government introduces an investment tax credit while also cutting personal income taxes, with government spending unchanged. Using the loanable funds market, explain the effect on (i) demand and/or supply, (ii) the equilibrium real interest rate, and (iii) private investment.
1 mark: Investment tax credit shifts demand for loanable funds right.
1 mark: Tax cut (with unchanged) reduces public saving, shifting supply left.
1 mark: Equilibrium real interest rate increases (both shifts push it up).
1 mark: Equilibrium quantity of loanable funds is indeterminate/ambiguous (depends on relative shift sizes).
1 mark: Private investment has opposing forces (higher demand encourages investment; higher real interest rate discourages).
1 mark: Clear statement that net effect on investment is uncertain without magnitudes (may rise or fall).
