Baruch Studio

eco-1002 · Long-run growth

Saving, Investment, and Crowding Out

The loanable funds market: how the real interest rate clears saving with investment, and how government deficits compete with firms for the same pool of funds.

⏱ 20 min Tags: loanable funds, crowding out, fiscal policy

Learning objectives

  • Describe supply (saving) and demand (investment) in the loanable funds market.
  • Explain how a government deficit shifts the supply of loanable funds.
  • Define crowding out and quantify it for a simple deficit shock.

The market for loanable funds

When a household saves a dollar, that dollar is supplied to the market for loanable funds (through banks, money market funds, or bond purchases). When a firm wants to build a factory it demands loanable funds (by issuing bonds, taking out a loan, or selling equity). The real interest rate is the price that clears this market.

Demand for loanable funds is investment II, which falls as the real rate rr rises. Supply is national saving: private saving plus government saving (a deficit is negative government saving). Saving rises with rr because the reward to deferring consumption is higher.

Estimated 10-year US real interest rate, monthly, from 1980 to 2024, using the Cleveland Fed model.
The Cleveland Fed's estimate of the 10-year real interest rate since 1980. Real rates fell from ~9% during the Volcker disinflation to near 0% by the mid-2010s, then rose sharply during the 2022 tightening. The model in this lesson is what determines this number; the chart is what the equilibrium has actually looked like.Source: FRED, St. Louis Fed (REAINTRATREARAT10Y)

Crowding out

Suppose the government runs a \300Bdeficit.NationalsavingfallsbyB deficit. National saving falls by $300Bateveryinterestrate—thesupplycurveshiftsleft.ThenewequilibriumhasahigherB at every interest rate — the supply curve shifts left. The new equilibrium has a higher r^andlowerand lowerI^$. The deficit crowds out private investment, dollar-for-dollar with the rise in saving the higher rate triggers, minus the part the higher rate elicits from private savers.

Equilibrium: r* = 3.64%, Investment I* = $1091B

A government budget deficit (positive value) means the government is borrowing from the same pool of saving that firms use to invest. That shifts the supply of loanable funds left, raises the real rate, and reduces equilibrium investment — crowding out.

Try setting the deficit slider to \300Bandwatchtheequilibriummove.Notehowmuchofthedeficitisabsorbedbyextraprivatesaving(thenewB and watch the equilibrium move. Note how much of the deficit is absorbed by extra private saving (the new r^*$ is higher) vs how much crowds out investment.

Why it matters for the economy

In the long run, investment becomes the capital stock that drives growth. A persistently large deficit means persistently less investment, which means a smaller capital stock and lower productivity than the economy would otherwise have. This is the long-run cost of deficits — separate from short-run cyclical effects.

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