AP_Krugman_Textbook

module 29 The Market for Loanable Funds 279

Section 5 The Financial Sector

Figure 29.2 shows the hypothetical supply of loanable funds. Again, the interest
rate plays the same role that the price plays in ordinary supply and demand analysis.
Savers incur an opportunity cost when they lend to a business; the funds could in-
stead be spent on consumption—say, a nice vacation. Whether a given individual be-
comes a lender by making funds available to borrowers depends on the interest rate
received in return. By saving your money today and earning interest on it, you are re-
warded with higher consumption in the future when your loan is repaid with interest.
So it is a good assumption that more people are willing to forgo current consumption
and make a loan when the interest rate is higher. As a result, our hypothetical supply
curve of loanable funds slopes upward. In Figure 29.2, lenders will supply $150 billion
to the loanable funds market at an interest rate of 4% (point X); if the interest rate
rises to 12%, the quantity of loanable funds supplied will rise to $450 billion (point Y).
The equilibrium interest rate is the interest rate at which the quantity of loanable
funds supplied equals the quantity of loanable funds demanded. As you can see in Fig-
ure 29.3 on the next page, the equilibrium interest rate, rE, and the total quantity of
lending,QE, are determined by the intersection of the supply and demand curves, at
pointE.Here, the equilibrium interest rate is 8%, at which $300 billion is lent and bor-
rowed. Investment spending projects with a rate of return of 8% or more are funded;
projects with a rate of return of less than 8% are not. Correspondingly, only lenders
who are willing to accept an interest rate of 8% or less will have their offers to lend
funds accepted.
Figure 29.3 shows how the market for loanable funds matches up desired savings
with desired investment spending: in equilibrium, the quantity of funds that savers
want to lend is equal to the quantity of funds that firms want to borrow. The figure
also shows that this match -up is efficient, in two senses. First, the right investments get
made: the investment spending projects that are actually financed have higher rates of
return than those that do not get financed. Second, the right people do the saving: the
potential savers who actually lend funds are willing to lend for lower interest rates than
those who do not. The insight that the loanable funds market leads to an efficient use
of savings, although drawn from a highly simplified model, has important implica-
tions for real life. As we’ll see shortly, it is the reason that a well -functioning financial
system increases an economy’s long -run economic growth rate.

figure 29.2

The Supply of

Loanable Funds

The supply curve for loanable funds slopes

upward: the higher the interest rate, the

greater the quantity of loanable funds sup-

plied. Here, increasing the interest rate

from 4% to 12% increases the quantity of

loanable funds supplied from $150 billion to

$450 billion.

0 $150 450

12%

4

Quantity of loanable funds

(billions of dollars)

Interest

rate, r

Supply of loanable funds, S

Y

X