Loanable Funds
The loanable funds framework models the real interest rate as the price that equilibrates saving supply and investment demand. It is the classical alternative to the Keynesian liquidity preference model for understanding what determines interest rates in the long run.
What loanable funds tracks
Loanable Funds sits at a specific point in the macro system. This section covers what the concept captures, what it leaves out, and why it matters.
In the mid-1980s, the U.S. ran large structural deficits following the Reagan tax cuts. Real interest rates were the highest since the postwar period. Many economists attributed the high rates to crowding out through the loanable funds mechanism: the government was absorbing saving that would otherwise have financed private investment. Whether the correlation reflected causation has been debated ever since.
The loanable funds model is the classical framework for thinking about real interest rates in the long run. It abstracts from money and focuses on the real flows of saving and investment that determine capital accumulation. It is not a complete model of short-run interest rate determination -- that requires IS-LM or its modern equivalents -- but it provides the long-run anchor around which those short-run models fluctuate.
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