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figure 29.4

An Increase in the Demand Interest
rate, r
for Loanable Funds
If the quantity of funds demanded by borrow- Section 5 The Financial Sector
S
ers rises at any given interest rate, the de-
mand for loanable funds shifts rightward from
D 1 to D 2 . As a result, the equilibrium interest An increase
rate rises from r 1 to r 2 . . . . leads to r 2 in the demand
a rise in the for loanable
equilibrium funds . . .
interest rate. r 1

D 2
D 1

Quantity of
loanable funds

The fact that an increase in the demand for loanable funds leads, other things
Crowding out occurs when a government
equal, to a rise in the interest rate has one especially important implication: beyond
deficit drives up the interest rate and leads to
concern about repayment, there are other reasons to be wary of government budget
reduced investment spending.
deficits. As we’ve already seen, an increase in the government’s deficit shifts the de-
mand curve for loanable funds to the right, which leads to a higher interest rate. If the
interest rate rises, businesses will cut back on their investment spending. So a rise in
the government budget deficit tends to reduce overall investment spending. Econo-
mists call the negative effect of government budget deficits on investment spending
crowding out. The threat of crowding out is a key source of concern about persistent
budget deficits.
Shifts of the Supply of Loanable Funds Like the demand for loanable funds, the sup-
ply of loanable funds can shift. Among the factors that can cause the supply of loan-
able funds to shift are the following:
■ Changes in private savings behavior: A number of factors can cause the level of private
savings to change at any given rate of interest. For example, between 2000 and 2006
rising home prices in the United States made many homeowners feel richer, making
them willing to spend more and save less. This had the effect of shifting the supply
of loanable funds to the left. The drop in home prices between 2006 and 2009 had
the opposite effect, shifting the supply of loanable funds to the right.
■ Changes in capital inflows: Capital flows into a country can change
as investors’ perceptions of that country change. For example,
Argentina experienced large capital inflows during much of the
1990s because international investors believed that economic re-
forms early in the decade had made it a safe place to put their
funds. By the late 1990s, however, there were signs of economic
trouble, and investors lost confidence, causing the inflow of
funds to dry up. As we’ve already seen, the United States has re-
ceived large capital inflows in recent years, with much of the
money coming from China and the Middle East. Those inflows
helped fuel a big increase in residential investment spending—
newly constructed homes—from 2003 to 2006. As a result of the Photodisc
worldwide slump, those inflows began to trail off in 2008.

module 29 The Market for Loanable Funds 281