Figure 1 depicts the market for loanable funds. The blue curve represents the demand for loanable funds, or the amount of funds that firms and individuals wish to borrow at each interest rate. The demand curve slopes downward because at a lower interest rate, firms and individuals can borrow money more cheaply. The lower cost of loans encourages a higher quantity of borrowing.
The red curve represents the supply of loanable funds, or the amount that individuals wish to save. The supply curve slopes upward because at a higher interest rate, individuals get a higher return on their money and are willing to save more. The point at which the supply and demand curves intersect is called the market equilibrium, and is marked E1 in Figure 1. At this point, the quantity of loanable funds demanded exactly equals the quantity supplied. This means that at the equilibrium interest rate, there are just enough people saving (supply) to match up with the desire for borrowing (demand).
What would happen if the market was out of equilibrium? Suppose that the interest rate in the market depicted in Figure 1 was 4%, rather than the equilibrium value of 6%. At a 4% interest rate, borrowers would demand $7000 worth of loanable funds, but suppliers would only be willing to provide $3000. The borrowers would compete for the insufficient supply, driving the interest rate up. This competition would continue until the interest rate reached 6%, the equilibrium point in this market.
Now let’s examine the Classical explanation of the loanable funds market. According to this theory, interest rate adjustments in the market for loanable funds ensure that any drop in consumption is matched by a corresponding increase in investment, so that aggregate demand can never fall. Let’s see how this works. Suppose that some individual, call her Mary, decides to consume $2000 less and save $2000 more. This shifts the supply of loanable funds curve to the right, because Mary makes an additional $2000 available at each interest rate. This shift is depicted in Figure 2. The demand curve remains unchanged, so the new equilibrium point is E2. The equilibrium quantity has risen from $5000 to $6000 and the equilibrium interest rate has fallen from 6% to 5%. The higher quantity implies that someone is borrowing and spending $1000 more. This additional quantity helps offset the demand “gap” created by Mary’s new act of saving. In addition, note that while Mary increased saving by $2000, the equilibrium quantity of saving increased by just $1000. As the interest rate falls, some other savers in the market decide to save $1000 less and consume $1000 more (this adjustment is depicted in the diagram as sliding down and to the left on the new green supply curve for saving). This increase in consumption of others provides the rest of the demand necessary to offset Mary’s higher saving. The classical theory uses this argument to show that an initial fall in consumption of $2000 leads to an increase in investment of $1000 and a $1000 increase in consumption. Despite Mary’s thriftiness, aggregate demand does not change. Demand is just reallocated across different people and institutions in the economy.
In response to the Classical argument, Keynesians introduce the Paradox of Thrift. Recall that the Paradox of Thrift says that when one individual increases her savings, she destroys income for someone else in the economy. This person must then reduce his savings or his consumption (or some mixture of the two). This process continues until the initial increase in saving is completely offset by reductions in saving due to falling incomes throughout the economy. For a more detailed description of this process, see the Paradox of Thrift.
In Figure 3, the paradox of thrift is illustrated in graphical form. The supply curve initially shifts rightward as one individual saves more, but then as other participants in the economy reduce their savings, the curve shifts back to its original position. In the end, the equilibrium point does not change and the quantity of loanable funds and interest rate remain the same. Overall savings has not increased, but the decline in consumption means that aggregate demand has fallen.