I n t h I s c h a p t e r y o u w I l L

interest rate,
you should remember that we are talk-
ing about the real interest rate.
This model of the supply and demand for loanable funds shows that financial
markets work much like other markets in the economy. In the market for milk, for
instance, the price of milk adjusts so that the quantity of milk supplied balances
the quantity of milk demanded. In this way, the invisible hand coordinates the be-
havior of dairy farmers and the behavior of milk drinkers. Once we realize that
saving represents the supply of loanable funds and investment represents the de-
mand, we can see how the invisible hand coordinates saving and investment.
When the interest rate adjusts to balance supply and demand in the market for
loanable funds, it coordinates the behavior of people who want to save (the sup-
pliers of loanable funds) and the behavior of people who want to invest (the de-
manders of loanable funds).
We can now use this analysis of the market for loanable funds to examine var-
ious government policies that affect the economy’s saving and investment. Be-
cause this model is just supply and demand in a particular market, we analyze any
policy using the three steps discussed in Chapter 4. First, we decide whether the
policy shifts the supply curve or the demand curve. Second, we determine the di-
rection of the shift. Third, we use the supply-and-demand diagram to see how the
equilibrium changes.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
5%
Supply
Demand
$1,200
F i g u r e 2 5 - 1
T
HE
M
ARKET FOR
L
OANABLE
F
UNDS
.
The interest rate in the
economy adjusts to balance the
supply and demand for loanable
funds. The supply of loanable
funds comes from national
saving, including both private
saving and public saving. 
The demand for loanable 
funds comes from firms and
households that want to borrow
for purposes of investment.
Here the equilibrium interest
rate is 5 percent, and $1,200
billion of loanable funds are
supplied and demanded.

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C H A P T E R 2 5
S AV I N G , I N V E S T M E N T, A N D T H E F I N A N C I A L S Y S T E M
5 6 7
Imagine that someone offered
to give you $100 today or
$100 in ten years. Which
would you choose? This is an
easy question. Getting $100
today is clearly better, because
you can always deposit the
money in a bank, still have it in
ten years, and earn interest
along the way. The lesson:
Money today is more valuable
than the same amount of
money in the future.
Now consider a harder
question: Imagine that someone offered you $100 today or
$200 in ten years. Which would you choose? To answer
this question, you need some way to compare sums of
money from different points in time. Economists do this
with a concept called present value. The 
present value
of
any future sum of money is the amount today that would
be needed, at current interest rates, to produce that fu-
ture sum.
To learn how to use the concept of present value, let’s
work through a couple of simple problems:
Question:
If you put $100 in a bank account today,
how much will it be wor th in 
N
years? That is, what will be
the future value of this $100?
Answer:
Let’s use 
r
to denote the interest rate ex-
pressed in decimal form (so an interest rate of 5 percent
means 
r
0.05). If interest is paid each year, and if the in-
terest paid remains in the bank account to earn more in-
terest (a process called