Supply and demand forces in the market for loanable funds determine the equilibrium interest rate. Some households, firms, residents of other countries, and even governments make funds available to financial markets (usually through the banking system) while other households, businesses, residents abroad, and governments desire to borrow funds. The interest rate aligns the interests of these groups; the quantity of funds supplied equals the quantity of funds demanded at the equilibrium interest rate.

The market for loanable funds is illustrated by the graph. The supply of loanable funds is upward sloping to reflect the desire of savers to save more at higher rates of interest: the opportunity cost of using funds today is higher, the higher the rate of interest. The demand for loanable funds is downward sloping: investments that are profitable at low interest rates may not be profitable at high interest rates. Currently, the market is in equilibrium at the interest rate i_e. To use the graph, shift either the supply or demand curve, as appropriate, by clicking on the curve’s label and, while holding down the mouse button, dragging the curve to the new location. Once the curves are in place, release the mouse button and click on the New Equilibrium button to observe the changes in the interest rate and quantities of loanable funds demanded and supplied.

1. How would the interest rate be affected by an increase in the desire of households to save additional amounts of their income?
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2. New technologies have increased the productivity of capital investment opportunities over the past decade. All else equal, what would this development do to the equilibrium rate of interest?
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3. During the latter part of the 1990s, the federal government’s budget position moved from deficit to surplus. How did this change affect the equilibrium interest rate?
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