We used a lot of equations

to think about the relationship

between savings and investment

but we can also use a graph.

As with any graph

the first step is to remind yourself

what's on the axis.

For this model,

the interest rate is on the vertical axis

and the total dollar volume

of savings and investment

in the overall economy

is on the horizontal axis.

The big picture is that

when households or the government

take in more than they spend

that difference is called savings.

How much do people want to save

that depends on a lot of things,

but one critical factor is the interest rate.

When you save money you earn interest.

Either you put that money in a bank

where it earns interest

or you buy financial instruments like bonds

which pay interest.

If the interest rate is 3%

saving $1,000 will earn me $30 in interest

over one period

but if the interest rate is 7%

that same $1,000 in savings

will earn me $70 in interest.

So the higher the interest rate

the more incentive I have to save money.

When you scale that up for all savers

you get a positive relationship

between the interest rate

and the volume of savings.

We call these savings

the supply of loanable funds,

because that's the amount of dollars

available to be lent to businesses.

On the other hand anyone who borrows money

has to pay interest.

So if the interest rate is 4%

a business that borrows $1,000

to buy a faster computer

will pay $40 in interest per period.

But if the interest rate is 8%

that same business will pay $80 in interest

on the same loan.

Because of the interest costs,

investments in new capital

like factories, office buildings,

airliners and bulldozers

will be less profitable

at high interest rates

than at low interest rates.

So that means that at high interest rates

businesses don't borrow much.

There's little demand for loans

but at low interest rates

plenty of investment projects are profitable

and borrowers borrow a lot.

That shows up as a negative relation

between the interest rate

and the volume of borrowing

which we call the demand for loanable funds.

So together we have the supply and demand

for loanable funds

which is why we call this

the loanable funds model.

As with our usual supply and demand

the intersection of the supply and demand

for loanable funds

gives us the equilibrium price.

In this case the price of money

is the interest rate.

At that equilibrium interest rate

and nowhere else the amount of loans

savers want to lend

equals the amount of loans

that borrowers desire.

Pick any other interest rate

and there will be a mismatch

between the amount of loans

savers are willing to make,

and the amount of loans the borrowers want.

Now whenever we have supply and demand

we need to think about shifts.

First what will shift the supply

of loanable funds?

Anything aside from the interest rate

that changes the saver's desire to save.

So for example

a new drug that expands lifespans

would induce people to save more money

for their longer retirements.

This would show up

as a rightward shift out

in the supply of loanable funds.

The interest rate would drop

and the volume of savings and investment

would increase.

On the other hand

suppose that we find an asteroid

headed for Earth

that will wipe out all life in three years,

there is really no point

in saving money for the future.

So people will save less.

This would show up

as a leftward shift inwards

of the supply of loanable funds.

The interest rate would rise

and the volume of savings and investment

would decrease.

Likewise, what could shift

the demand for loanable funds?

Anything assigned from the interest rate

that changes businesses' need

to borrow to invest.

For example suppose

new airliners and delivery trucks

were invented with double the fuel efficiency

of past models.

Airlines and delivery firms

would scramble to borrow money

to buy this new equipment.

This would show up

as a rightward shift out

in the demand for loanable funds.

The interest rate would rise

and the volume of savings and investment

would increase.

On the other hand

suppose that businesses

anticipate a recession,

with a drop in consumer purchases

businesses won't be fully using

their existing capacity.

So there's no need for them to borrow

to invest in yet more capacity.

This would show up as a leftward shift

for the demand for loanable funds.

The interest rate would fall

and the volume of savings and investment

would decrease.