Course: Prin Macroeconomics, University of Florida
Source: Chapter 9 – Finance, Savings, and Investments
Tags: finance, savings, investment, loanable funds, interest rate, bonds, stocks, crowding out, budget deficit, macroeconomics
Difficulty: Introductory Prerequisites: Basic understanding of supply and demand (Chapter 3/4 notes recommended). Familiarity with GDP components is helpful but not essential.
This chapter explains how money moves between people who save and people who want to borrow. Financial markets (loans, bonds, stocks) and financial institutions (banks, mutual funds, pension funds) are the plumbing that connects savers to borrowers. The central model is the market for loanable funds, which applies supply-and-demand logic to determine interest rates. You will also see how government borrowing competes with private borrowing, a concept called the crowding-out effect. If you are comfortable with basic supply and demand curves, you already have the main toolkit you need.
Savers supply funds and borrowers demand them; the real interest rate is the price that balances the two sides. Banks, bond markets, and stock markets each channel savings into investment differently. When the government runs a deficit and borrows heavily, it pushes interest rates up and crowds out private investment.
Income
Funds that an individual or household brings in during a specified period of time, usually a month or year. In simple terms, this is the money coming in before anything is taken out.
Disposable income
Income minus taxes. Think of it as the money you can actually decide what to do with.
Saving
The portion of disposable income that is not spent on goods and services during the specified period of time. In simple terms, saving is whatever you did not spend.
Wealth
The value of all assets that an individual or household owns, including prior saving. Think of it as a running total of everything you have accumulated, not just what you earned this month.
Financial intermediary
An institution (such as a bank) that channels funds from savers to borrowers. In simple terms, the middleman between people with spare cash and people who need to borrow.
Bond
A right to payment in the future, issued by governments or companies to raise funds. The issuer pays back the bondholder with interest. The interest rate reflects the riskiness of the bond (how likely the issuer is to repay). Think of it as an IOU with a promised interest payment.
Stock (equity share)
A small share of ownership in a corporation. Companies sell shares through IPOs to raise capital, and shareholders can later resell on the stock market. In simple terms, buying a stock means owning a tiny piece of the company.
Buyback
When a firm repurchases its own shares from the market, often because it has excess cash. This reduces the number of shares outstanding and tends to drive the stock price up.
Market for loanable funds
A macroeconomic model that represents the aggregate of all financial markets. The price in this market is the real interest rate; the quantity is the total amount of funds lent and borrowed. Think of it as a single, simplified picture of every place savers and borrowers meet.
Crowding-out effect
When government borrowing to fund spending increases the demand for loanable funds, pushing up interest rates and reducing private investment in physical capital. In simple terms, the government "elbows out" private borrowers by competing for the same pool of savings.
Budget deficit
Occurs when government spending exceeds tax collection. The government must borrow to cover the gap, which adds to the demand for loanable funds.
Interest rate differential
The difference between the interest rate a bank charges borrowers and the rate it pays depositors. This spread is a traditional source of bank profit.
Financial markets are the places (physical or virtual) where savers and borrowers meet. There are three main types.
Loan markets
Banks act as financial intermediaries, sitting between depositors and borrowers.
Historically, banks lent out large portions of depositors' savings and charged borrowers an interest rate. A portion of that interest was paid back to depositors; the remainder (the interest rate differential) was the bank's profit.
Modern banks have diversified revenue streams, but the intermediary function remains central.
Bond markets
Governments and companies issue bonds to raise funds.
A bond is a promise to repay a set amount in the future, plus interest. The issuer "buys back" the bond at maturity.
The interest rate on a bond reflects its riskiness, which is simply how likely the issuer is to repay you.
Higher risk of default means the issuer must offer a higher interest rate to attract buyers.
Stock markets
Corporations sell shares (small ownership stakes) to raise capital.
An IPO (initial public offering) is the first time a company sells shares to the public, directly funding the firm.
After the IPO, shares trade on the secondary market; the company does not receive money from those trades.
Buybacks occur when a firm repurchases its own shares, often because it has excess cash. This reduces shares outstanding and tends to push the stock price up, which benefits managers who hold equity.
Financial institutions are the organisations that operate within financial markets. Each type plays a distinct role in channelling savings toward investment.
Commercial banks
Accept deposits and make loans. The classic intermediary.
Earn revenue primarily through the interest rate differential (the spread between what they charge borrowers and what they pay depositors).
Government-backed mortgage companies
The government encourages home ownership by reducing the riskiness of mortgage lending.
Banks are permitted to seize and sell the house if the borrower defaults (collateral).
The government also insures the lender, absorbing some of the default risk. This makes banks willing to issue more mortgage loans than they otherwise would.
Pension funds
Collect contributions from working populations and distribute payouts to retirees.
Act as large institutional investors, pooling contributions and investing them in diversified portfolios.
Mutual funds
Pool money from many individual investors. A fund manager selects a portfolio of stocks and bonds.
Shares in the fund grow in value if the portfolio performs well.
Investors can liquidate (sell) their shares to cash out.
Insurance companies
Collect premiums from a large group of people who face specific risks (illness, property damage, death).
Pay out to those for whom the risk materialises.
The model works because the risk events do not happen to everyone at once, so premiums from the many cover claims from the few.
The market for loanable funds is the key model for this chapter. It is a macroeconomic model that represents the aggregate of all financial markets in a single supply-and-demand diagram.
The axes
Vertical axis: Real interest rate (%)
Horizontal axis: Quantity of loanable funds ($)
The price of a loan is the interest. The principal (the amount borrowed) is paid back, so it is a wash. The interest is what the borrower pays for access to money now rather than saving up for it.
Demand curve (borrowers)
Slopes downward. As the real interest rate falls, more physical capital investments have expected rates of return that exceed the interest cost, so borrowers take out more loans.
Supply curve (savers/lenders)
Slopes upward. As the real interest rate rises, the return on saving increases, so individuals and firms save more.
Expected profitability of business (+)
If businesses expect investments in physical capital to be more profitable, they demand more loans to fund those investments. The demand curve shifts right.
Business taxes (inverse / negative)
Higher taxes reduce after-tax profitability, so firms invest less and demand fewer loans. The demand curve shifts left.
Disposable income (+)
People save more when their disposable income rises. Supply shifts right.
Expected future income (negative relationship)
If people expect income to increase in the future, they spend more today and save less now (supply shifts left).
If people expect income to fall, they cut back spending today and save more (supply shifts right).
Value of household wealth (negative)
When the value of assets such as houses rises, people feel wealthier and tend to save less. Supply shifts left.
Default risk (negative)
Default risk is the likelihood that a loan will not be repaid. When perceived risk is high, lenders are less willing to lend, so the supply of loans decreases. Supply shifts left.
When the government runs a budget deficit (spending exceeds tax revenue), it must borrow to cover the shortfall. In the loanable funds model, this shows up as an increase in demand.
How it works in the model
The demand curve shifts right by the amount of the deficit. The government's borrowing is added on top of private borrowing.
The new equilibrium has a higher real interest rate.
At the higher rate, private borrowers borrow less than they would have at the original rate.
The crowding-out effect
Because government borrowing pushes interest rates up, private firms find it more expensive to borrow for physical capital investment.
Private investment falls. The government's spending "crowds out" private spending.
Total borrowing rises, but the private sector's share of that total shrinks.
Reading the graph
The distance between the old and new demand curves equals the size of the government deficit.
The equilibrium interest rate rises.
Private sector borrowing = total borrowing minus the government's borrowing.
The gap between what private borrowers would have borrowed at the old rate and what they borrow at the new rate is the amount crowded out.
The interest rate on your savings account, your mortgage rate, and the yield on a government bond are all determined by the same underlying forces this chapter describes: the supply of savings and the demand for borrowing.
Crowding out is a live policy debate. When governments run large deficits (as many did during the COVID-19 pandemic), economists watch whether rising government borrowing pushes up interest rates and discourages private investment. The loanable funds model gives you the framework to follow those arguments.
Stock buybacks regularly appear in financial news. When a company announces a large buyback programme, its share price often rises because fewer shares are chasing the same underlying value. Understanding why requires exactly the ownership logic covered here.
Students often confuse saving (a flow, what you do not spend this period) with wealth (a stock, the total value of everything you own). Saving adds to wealth, but they are different concepts.
Students sometimes think the interest rate is a fee the bank invents. In the loanable funds model, the interest rate is a market price determined by supply and demand, just like any other price.
A common mistake is thinking government borrowing only shifts the supply curve. It shifts the demand curve to the right: the government is a borrower, not a saver.
Students often assume crowding out means private investment drops to zero. It does not. Private investment decreases, but it does not disappear entirely. The crowding out is partial.
Be able to draw the loanable funds diagram from memory: label the axes (real interest rate vs. quantity of loanable funds), draw the upward-sloping supply and downward-sloping demand, and mark the equilibrium.
Know every demand and supply shifter and its direction. Expect questions that give you a scenario ("disposable income rises") and ask which curve shifts and which way.
Be ready to illustrate the crowding-out effect graphically: show the demand shift from a budget deficit, the new equilibrium interest rate, and the reduction in private borrowing.
Understand the difference between the three financial markets (loan, bond, stock) and why each exists. A common exam format lists a scenario and asks which market is involved.
Know all five financial institutions and what each does. Multiple-choice questions often test whether you can match the institution to its function.
True or False: Saving and wealth mean the same thing. False. Saving is a flow (income not spent in a period); wealth is a stock (total accumulated assets).
Fill in the blank: The price in the market for loanable funds is the ________. Real interest rate.
True or False: When the government runs a budget deficit, the supply of loanable funds shifts right. False. The demand curve shifts right. The government is borrowing, not saving.
Fill in the blank: The crowding-out effect causes private ________ to decrease. Investment (in physical capital).
True or False: A bond's interest rate is unrelated to the issuer's risk of default. False. Higher default risk means a higher interest rate to compensate lenders.
Q: If businesses expect higher profits from new capital investments, what happens in the market for loanable funds?
A: The demand for loanable funds shifts right, increasing the equilibrium real interest rate and the quantity of funds borrowed.
Q: A household's disposable income rises. How does this affect the supply of loanable funds?
A: The supply of loanable funds shifts right (increases), because people save more when disposable income rises. The equilibrium interest rate falls and quantity of funds increases.
Q: The government increases spending without raising taxes, creating a larger budget deficit. Explain the crowding-out effect.
A: The government must borrow more, shifting the demand for loanable funds to the right. This pushes the real interest rate up. At the higher rate, private firms find borrowing more expensive and reduce their investment in physical capital. Private investment is "crowded out."
Q: Why does the supply curve for loanable funds slope upward?
A: As the real interest rate rises, savers earn a higher return on their savings, which encourages more saving. Higher reward for saving means more funds supplied.
Q: Explain how a mutual fund differs from a commercial bank as a financial institution.
A: A commercial bank takes deposits and makes loans, earning profit from the interest rate differential. A mutual fund pools money from many investors and invests it in a portfolio of stocks and bonds chosen by a fund manager. The bank acts as an intermediary in the loan market; the mutual fund channels savings into the stock and bond markets.
Q: If people expect their future income to fall, what happens to the supply of loanable funds today?
A: Supply shifts right (increases). People cut back on spending today and save more as a precaution, increasing the quantity of funds available for lending.
This chapter connects directly to aggregate demand and aggregate supply (typically covered a few chapters later). Changes in investment, driven by interest rates in the loanable funds market, feed into the investment component of GDP (Y = C + I + G + NX).
The crowding-out effect reappears in discussions of fiscal policy. When you study government spending multipliers, the crowding-out effect is the reason the actual multiplier is smaller than the simple textbook formula suggests.
Default risk and bond pricing link forward to monetary policy. When the central bank adjusts interest rates, it is operating on the same mechanism described here, just from the supply side rather than the demand side.
Financial markets, financial institutions, loanable funds, loanable funds market, real interest rate, nominal interest rate, saving vs. savings, disposable income, wealth, bonds, stocks, equities, IPO, initial public offering, buyback, share repurchase, commercial bank, pension fund, mutual fund, insurance company, government-backed mortgage, demand shifters, supply shifters, expected profitability, business taxes, default risk, household wealth, budget deficit, crowding out, crowding-out effect, fiscal policy, government borrowing, interest rate differential, financial intermediary, Prin Macroeconomics, University of Florida, Chapter 9