These notes explain how the loanable funds model links government borrowing to the real interest rate and private investment. You should be able to describe the market, show shifts, and interpret “crowding out.”

The Loanable Funds Model: What the Graph Represents

The loanable funds market is a model of how saving is channelled into borrowing for spending on capital goods and other uses. The “price” in this market is the real interest rate, and the “quantity” is the amount of funds lent/borrowed.

In the standard AP graph:

• Vertical axis: real interest rate ($r$)

• Horizontal axis: quantity of loanable funds

• Supply curve: national saving (upward sloping in $r$)

• Demand curve: borrowing to finance private investment and, when relevant, government borrowing (downward sloping in $r$)

Why the Curves Slope the Way They Do

• Supply (saving) slopes up: higher $r$ increases the reward to saving and encourages more saving.

• Demand (borrowing) slopes down: higher $r$ raises borrowing costs, so fewer investment projects are profitable.

Adding Government Borrowing to the Model

Government borrowing matters because it uses part of the economy’s pool of saving. In the loanable funds framework, a budget deficit typically implies the government enters the borrowing market, increasing total demand for funds.

A helpful way to connect the model to national accounting is:

This identity clarifies that when $(G-T)$ rises, the overall demand for loanable funds rises unless offset by a change in $S$.

Showing Crowding Out with the Loanable Funds Graph

Crowding out in this model is shown when government borrowing pushes up the equilibrium real interest rate, which reduces private investment.

Step-by-Step: The Standard “Demand Shifts Right” Story

• Start at equilibrium where saving supply intersects borrowing demand.

• Government runs a larger deficit and borrows more.

• This increases total borrowing at each interest rate:

  • The demand for loanable funds shifts right (from $D_1$ to $D_2$).

• The new equilibrium has:

  • higher $r$ (real interest rate rises)

  • higher quantity of loanable funds exchanged (more total borrowing/lending)

• Because investment is a component of demand and is interest-rate sensitive:

  • private investment falls relative to what it would have been without the deficit

  • the government absorbs some funds that would otherwise finance investment

What You Must Label/State for AP Credit

• Identify the initial equilibrium ($r_1$, $Q_1$) and new equilibrium ($r_2$, $Q_2$)

Loanable funds market diagram (Graph AB-6) illustrating crowding out: government borrowing adds to demand ($D_1 \rightarrow D_2$), raising the equilibrium real interest rate from $r_1$ to $r_2$. The equilibrium quantity of loanable funds increases from $Q_1$ to $Q_2$, while private borrowing along the original private-demand curve is reduced at the higher interest rate. This visual is well-suited for labeling $r_1, r_2, Q_1,$ and $Q_2$ exactly as AP graders expect. Source

• Explicitly state: $r$ rises

• Explicitly state: private investment decreases (crowded out), even though total borrowing may rise

How Much Crowding Out Occurs (Graph Intuition)

The magnitude depends on the responsiveness of saving and investment:

• If saving supply is inelastic (steep), a rightward demand shift causes a large rise in $r$ and more crowding out.

• If investment demand is elastic (flat), a small rise in $r$ causes a large drop in investment, increasing crowding out.

• If saving is highly responsive (flatter supply), increased borrowing can be accommodated with a smaller increase in $r$, so crowding out is smaller.

Common Interpretation Errors to Avoid

• Crowding out is about private investment, not “all private spending.”

• The model uses the real interest rate (inflation-adjusted), not necessarily the nominal rate.

• On the graph, government borrowing typically appears as a rightward shift in demand, not a shift in supply (unless the policy directly changes saving behaviour).