What is Loanable Funds Theory of Interest?

The famous Swedish economist, Knut Wicksell, expounded the loanable-funds theory of interest, also known as the neo-classical theory of interest.

The loanable funds theory is an attempt to improve upon the classical theory of interest. It recognises that money can play a disturbing role in the saving and investment processes and thereby causes variations in the level of income.

Thus, it is a monetary approach to the theory of interest, as distinguished from that of the classical economists. In fact, the loanable funds theory synthesises both the monetary and non-monetary aspects of the problem.

According to the loanable funds theory, the rate of interest is the price that equates the demand for and supply of loanable funds.

Thus, fluctuations in the rate of interest arise from variations either in the demand for loans or in the supply of loans or credit funds available for lending.

This implies that interest is the price that equates the demand for loanable funds with the supply of loanable funds.

Loanable funds are "the sums of money supplied and demanded at any time in the money market."

The supply of 'credit' or funds available for lending would be influenced by the savings of the people and the additions to the money supply (usually through credit creation by banks) during that period.

Thus, the supply of loanable funds is constituted by the savings. (S) plus new money (new money supply resulting from credit creation by commercial banks). Thus, S + M is the total supply of loanable funds.

The demand side of the loanable funds, on the other hand, would be determined by the demand for investment plus the demand for hoarding money.

It should be noted here that if the hoarded money increases, there would be a curtailment corresponding in the supply of funds. Similarly, an increase in dishoarding will lead to an increase in the supply of loanable funds.

In short, thus, the demand for loanable funds is constituted by the investment expenditure a demand for investible fund (/) plus net hoarding (H), i.e., the demand for loanable funds for use as inactive cash balances. Thus, I + H is the total demand for loanable funds.

Thus, according to the loanable funds theory, the rate of interest is determined when the demand for loanable funds (I + H) and the supply of loanable funds (S + M) balance each other.

Evidently, the loanable funds theory is wider in scope than the classical theory. The classical theory considers the rate of interest as a function of saving and investment only. Symbolically:

r = f (I, S),

Where, r denotes the rate of interest, I stand for investment and S for saving.

The loanable funds theory regards the rate of interest as the function of four variables: savings (S); investment (I); the desire to hoard (H); and the money supply (M), i.e., newly created money or bank credit (including money dishoarded). Symbolically:

r = f (I,S,M,H).

It is interesting to note here that Wicksell, when he formulated his theory, regarded bank credit a constituent of loanable-fund supply as interest-inelastic, for he believed bank credit creation depends upon the liquidity position, of the banks and is not affected by changes in the interest rate.

Thus, he considered the money supply (M) schedule to be constant in loanable funds. He took into account investment demand only and neglected the hoarding aspect of money.

But other economists later on refined the Wicksellian theory of loanable funds and took into the consideration the tendency to hoard, the (H) variable.

Furthermore, in the refined version, the (M) schedule is not regarded as interest inelastic or constant. It was felt that this is incorrect.

The banks will be less willing to create credit if the rate of interest is low, and they will be inclined to expand credit when the rate of interest is high. Thus, the bank credit or money supply (M) schedule was considered to be interest-elastic by the later economists.

The supply side of loanable funds is composed as under:

1. The M curve stands for the supply of money bank credit (including dishoarding). It slopes upward indicating that the supply of bank credit is interest-elastic.

2. The S curve denotes the different amounts of saving available at different levels of the rate of interest. It slopes upward indicating that there is a direct relationship between the volume of saving and the rate of interest. The higher the rate of interest, the higher the volume of savings and vice versa.

3. The S + M curve indicates the total supply of loanable funds available at different rates of interest. It is derived by combining together the S and M curves. The S + M curve, also slopes upwards, indicating that the higher rate of interest, the higher the supply of loanable funds, and vice versa.

The demand for loanable funds is considered as under:

1. The curve / stands for the investment demand for savings. It slopes downward to represent an inverse relationship between the volume of investment and the rate of interest. That is to say, the higher the rate of interest, the lower the investment demands, and vice versa.

2. The curve H represents the tendency to hoard money (or the level of hoarding) at different levels of the rate of interest. It is a downward sloping curve implying that the higher the rate of interest, the lower the hoarding (of idle cash balances), and vice versa.

3. The curve I + H represent the total demand for loanable funds at different rates of interest. It has been obtained by combining together the / and H curves. The I + H curve also slopes downwards, because the lower the rate of interest, the higher is the demand for loanable funds, and vice versa.

The I + H (loanable funds demand) curve and the S + M (loanable funds supply) curve intersect at point E, which indicates the level of the market rate for interest (OR). Thus, the rate of interest is determined by the intersection of the demand for loanable funds and the supply of loanable funds.

This diagram also serves to explain the differences between the classical theory and the loanable funds theory.

In the classical theory, the interest rate is determined by the intersection of the savings and investment curves (S, I), while according to the loanable funds theory, the rate of interest is determined by the intersection of the S + M and I + H curves.

In the diagram, thus, the classical rate of interest would be OR 1 whereas, according to the loanable funds version, there is a discrepancy between savings and investment expenditure.

This discrepancy is equal to the algebraic sum of net money (M), and net hoarding (H). Thus, the loanable funds theory shows that money no longer plays a passive or natural role. Its inclusion on the supply side brings the rate of interest down to OR, as against OR in real terms.

The diagram also, elucidates the Wicksellian distinction, between the natural rate of interest and the market rate of interest. OR 1 is the natural rate of interest, at which saving equals investment, in real terms, while OR is the market rate of interest at which the demand for loanable funds equals the supply of loanable funds, in money terms.

Thus, the loanable funds theory marks an improvement over the classical theory on the following counts:

1. The loanable funds theory is more realistic than the classical theory. The former is stated in real as well as money terms, whereas the latter is stated only in real terms. The rate of interest is a monetary phenomenon. Therefore, a theory stated in money terms seems more realistic.

2. The loanable funds theory recognises the active and dynamic role of money in a modern economy, while the classical economists regarded money just as a technical device and a passive factor.

3. The loanable funds theory distinctly considers bank credit as a component of money supply, influencing the rate of interest. This was overlooked by the classicists.

4. Unlike the classical theorists, the expounders of the loanable funds theory takes into account the rate of hoarding (inactive cash balances) as a factor affecting the demand for loanable funds).

Criticisms:

The following shortcomings of the loanable funds theory are noteworthy:

1. Hansen critcises the loanable funds theory as not providing us with a determinate solution to the problem of rate of interest.

The supply schedule of loanable funds comprises new "savings" portion of the schedule varies with the level of disposable income (in the Robertsonian sense, "yesterday's income"), it follows that the total supply schedule of loanable funds also varies with income.

Therefore, the rate of interest cannot be known unless the level of income is known; and the level of income cannot be known unless the rate of interest is known. Thus, like the classical theory, this theory is also indeterminate.

2. Furthermore, according to the loanable funds theory, the supply of loanable funds is sometimes increased by a release of cash balances, and sometimes diminished by the absorption of various savings into cash balances.

This gives the impression that the cash balances of the community can be increased or decreased. This, however, is not actually the case. The total amount of cash balances of a community are, at any time, fixed and necessarily equal to the total amount of money supply.

The members of a community may, of course, attempt to increase or decrease the total amount of their cash balances but such an attempt cannot result in an actual increase or decrease in the amount of cash balances.

It can only result in a change in the velocity of circulation of money. This, no doubt, would result in an increase or decrease in the supply of loanable funds.

Thus, the basic contention of the loanable funds theory that an attempt to change the volume of cash balances results in a change in the supply of loanable funds is correct. But, the way in which it is presented is not quite satisfactory.

3. Some critics have objected to the way monetary factors have been combined with real factors in the loanable funds theory. The critics argue that it is illogical to combine factors, like saving and investment, with monetary factors, like bank credit and liquidity preference.

4. The theory is an exaggeration of the functional relationship between the rate of interest and savings. Critics argue that people usually save not for the sake of interest but out of precautionary motives, where propensity to save is interest- inelastic.