In the loanable funds market, what determines the real interest rate and how does it relate to investment?

• A. Real interest rate is set by the central bank; higher rates increase investment.
• B. Real interest rate equals the price of bonds; higher rates increase saving but do not affect investment.
• C. The intersection of saving supply and investment demand sets the real interest rate; higher rates discourage investment, lower rates encourage it.
• D. The government budget balance determines the rate; deficits push rates up and investment up.

Answer: (C)

In the loanable funds market, the real interest rate is the price that equilibrates saving and investment. Savers supply funds and firms or other borrowers demand them for investment. The rate adjusts until the quantity of funds supplied equals the quantity demanded. When the real rate is higher, borrowing costs rise and investment becomes less attractive, while savers earn more from saving, so the supply of loanable funds tends to be stronger. When the real rate is lower, borrowing is cheaper and investment rises, while saving becomes less attractive, reducing the supply of loanable funds. The equilibrium rate is where these two sides meet, and at that point, the level of investment is determined by how sensitive investment is to changes in the rate.

That’s why this option is the best: it captures that the rate is set by the intersection of saving and investment, and that higher rates discourage investment while lower rates encourage it. The other statements misstate who sets the rate or what it represents in this framework—for example, central banks or bond prices aren’t the defining mechanism in the basic loanable funds model, and while deficits can influence saving and investment, they don’t deterministically fix the rate in the way described.