The money market sets the nominal interest rate in the short run. A second market, built like any supply and demand market, shows how saving and borrowing set the Nominal and Real Interest Rates, and how government deficits fit in.
Key idea
In the loanable funds market, the supply of loanable funds comes from saving (by households, by a government running a surplus, and by foreigners lending here) and the demand comes from borrowing (mainly firms investing, plus a government borrowing to cover a deficit). They set the real interest rate.
Why it works
Savers lend more when the real return is higher, so supply slopes up. Borrowers invest in projects that pay more than the real interest rate, so at a lower rate more projects are worth doing: demand slopes down. Anything that changes saving at every rate shifts supply; anything that changes borrowing at every rate shifts demand. When the government borrows more, it competes with firms for the same pool of saving, so (in this course's framing) demand shifts right and the real rate rises.
Worked examples
Worked example: Which curve?
What happens to the real interest rate? (a) Households decide to save more. (b) An investment tax credit makes new factories more profitable.
- (a) More saving: supply shifts right, and the real rate falls.
- (b) More borrowing for investment: demand shifts right, and the real rate rises.
Answer: (a) falls; (b) rises
Worked example: Finding equilibrium
Supply: $r = 1 + 0.01Q$. Demand: $r = 9 - 0.01Q$ ($Q$ in billions, $r$ in percent). Find the equilibrium.
- $1 + 0.01Q = 9 - 0.01Q$, so $0.02Q = 8$ and $Q = 400$.
- $r = 1 + 0.01(400) = 5\%$.
Answer: $Q = 400$ billion, $r = 5\%$
| Loanable funds market | Money market | |
|---|---|---|
| Price on the vertical axis | real interest rate | nominal interest rate |
| Supply | saving | money supply (central bank) |
| Demand | borrowing | money demand |
Common mistake
Mixing up the money market (nominal rate, money supply and demand) with the loanable funds market (real rate, saving and borrowing), and shifting the wrong curve when the government borrows. A deficit adds to the demand for loanable funds (some textbooks show it instead as less public saving, a leftward supply shift; the rate rises either way). Check: is the event about saving or about borrowing?