The market for loanable funds describes how that borrowing happens. The supply of loanable funds is based on savings. The demand for loanable funds is based on borrowing. The interaction between the supply of savings and the demand for loans determines the real interest rate and how much is loaned out.
Anything that changes investment demand will change the demand for loanable funds. Examples of events that can shift the demand for loanable funds are
There is an important implication of that first determinant of investment demand: real interest rates are procyclical. When the economy is doing well, the rate of return on any investment spending will increase. That means the demand for loanable funds will increase, which leads to a higher real interest rate. In other words, we would expect to see an increase in real interest rates, and the quantity of loans made, when the economy is doing well.
Some government policies, such as investment tax credits, basically lower the cost of borrowing money at every real interest rate. Such policies would increase the demand for loanable funds. Other policies, such as budget deficits, might increase the demand for loanable funds.
A budget deficit occurs when the government expenditures are greater than the revenues it receives. This can arise from either a shortfall of revenue, an increase in expenditures, or both. Government spending is divided up into what is called discretionary and mandatory spending. Discretionary spending is optional, and can be implemented at any time, as long as Congress approves the bill without a presidential veto This is 4 different from mandatory spending, which is spending that is built into the budget and required by law. Examples of mandatory spending are Social Security and Medicare
As interest rates rise, people are more likely to save. The demand curve represents the demand for investment funds. It has a downward slope because as interest rates increase, assuming other economic factors are constant, businesses generally want to invest less. Suppose government borrows money to run a budget deficit. This would shift the demand for loanable funds out. This has the effect of raising the interest rate, which makes investment more expensive.In the classical model, the loanable funds market, if left to itself, would balance out savings and investment, thereby keeping the economy at or close to full employment. There would be no need for government deficit spending, and such spending would be counterproductive because the crowding out effect means that the effect of deficit spending would be to shift funds from investment to government consumption. For this reason, classically-oriented economists generally oppose government deficit spending
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