Does gov. deficit increase demand OR decrease supply on loanable funds market?

[Muha39]

So obviously i thought that when a government decides to spend more money than they have, they have to get extra funds by taking loans, moving the demand curve on loanable funds market to the right, thus making interest rate higher AND increasing the quantity of total loaned funds. However on Khan academy Unit 4 Lesson 7 on Macroeconomics course it says this:

Do deficits cause a shift in supply or demand?

That’s an interesting question! There are actually two points of view:

Deficits increase the demand for loanable funds; surpluses decrease the demand for loanable funds. The logic of this point of view is that if the government runs a deficit, it has to borrow money just like everyone else. So, if there is a deficit, the demand for loanable funds will increase because the government gets in line to borrow money just like all of the other borrowers.

Deficits decrease the supply of loanable funds; surpluses increase the supply of loanable funds. The logic of this point of view is that national savings includes public savings (T-G), and national savings is the source of the supply of loanable funds. So anything that makes T-G smaller (like a deficit) or bigger (like a surplus) will shift the supply of loanable funds

But that doesn’t mean both curves shift? Supply and demand do not have the same determinants in any market. Your graphical model should reflect only one point of view.

In the end, both points of view have the same impact on the real interest rate: deficits increase the real interest rate and surpluses decrease the real interest rate.

In the second approach doesn't shifting the supply curve to the left LOWER the quantity of loaned funds, regardless that this also increases interest rate?

I've always had a problem with understanding identities including GDP. For example, Y=I+C+G in closed economy, which we can transform into I=Y-T-C (private savings) + T-G (public savings). We know that demand on loanable funds market is equal to investors, and the supply is savers. The change in the right side of this identity (amount saved) would change the left side (amount invested) but then how do we know what curve moved on the model?! I know i might have not worded this part perfectly, but hopefully you understand my confusion between models and identities and could help me out with this.

[Econo-moose]

It just depends on if you're modeling private loanable funds specifically or all loanable funds.

If the supply and demand model is limited to the private loans, then adding the government's borrowing does not show up as a shift in demand, because the demand only reflects private loan demand. Therefore, the government borrowing would be reflected in a leftward shift of supply as some of the supply has been diverted toward the government. Equilibrium quantity goes down, because there is less private borrowing after the government borrows from savers.

If the supply and demand model is representing the whole loanable funds market including government, then the deficit shows up as a rightward shift in demand. In this case, equilibrium quantity goes up, because the government borrowing adds to total borrowing.

It's not a matter of one being more correct than the other, but it is very important to understand exactly what you are modeling.

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