As described in the previous lesson, savings and investment are affected primarily by the interest rate. For savings, interest rate is directly related and creates a positive slope between the two, because as interest rates increase, saving becomes more lucrative, so people invest more. For investment, interest rate is indirectly related and creates a negative slope, because the cost of a loan increases as interest rates increase. When displayed on a graph of real interest rate vs. quantity of money, we see that we have a basic supply and demand graph. This is what is known as the loanable funds graph or the loanable funds market (the amount of money used in savings and investment for an economy). Examine the following graph:
Loanable Funds Market
Notice that in the graph above, the quantity of money is displayed on the x-axis while the real interest rate is displayed on the y-axis. It is important to remember that the real interest rate is used for this graph, NOT the nominal interest rate. On the graph, “real interest rate” should be written on top of the y-axis (or near the top) and “r” may be used to abbreviate along the y-axis. (Again, it is important to use “r” NOT “I” or “IR”.) In the graph above as well as all other loanable funds graphs, we used “S” to represent savings and “D” to represent investment. It is perfectly acceptable to use these abbreviations on the graph but it is important to remember supply is savings and demand is investment. Read more about the Loanable Funds Market
Because there are no specific determinants that shift savings and investment, it
is important to use some common sense and critical thinking to understand an action’s effect on the loanable funds market. It is important to know that not all actions will affect the loanable funds (in the short run at least). An example of a shift in the market may be something like the following: “Income taxes in the U.S. decrease. What effect does this have on the real interest rate in the U.S.?” In this case, lower income taxes would allow people to save more money as they have more money available. This would shift the supply curve (the savings curve) to the right. A new equilibrium point would be established at a lower real interest rate.
Perhaps the most common shift of the loanable funds market is the crowding out effect. The crowding out effect occurs when a government runs a budget deficit (it spends more money than it collects), causing the real interest rate to increase, and private investment to decrease because it becomes “crowded out”. When a government runs a deficit, it must borrow money to pay for its debt (this is commonly done through the sale of bonds). People respond by buying these bonds, consequently absorbing the debt, with their personal savings. This causes the supply of loanable funds (savings curve) to decrease and causes a shift left in the curve. The leftward shift creates a new equilibrium point at a higher interest rate. At this higher interest rate, businesses refrain from investing due to the new higher price of the loan. This ultimately leads to a slow down in the economy, as growth occurs at a slower pace or does not occur at all.