Loanable Funds Theory Of Interest Rate Determination

The Loanable Funds Theory of interest was formulated by Neo-classical economists like Wicksted, Robertson, etc. According to this theory, the rate of interest is determined by the demand for and supply of loanable funds. So, according to this theory the rate of interest depends upon demand and supply of loanable funds. The term ‘Loanable Funds‘ means funds or the amount of money which will be lent for interest.

Sources of the Supply of loanable funds :

The supply of loanable is derived from four sources. They are:

1. Savings : The most important source of loanable funds is the savings made by individuals or families. The amount of savings depends upon the rate of interest. The higher the rate of interest, the higher will be the amount of savings and vice versa. So, the amount of savings varies with the rate of interest.

2. Dishoarding: Another important source of loanable funds is the dishoarding. Whenever the rate of interest increases, people dishoard money and then the supply of loanable funds will increase and vice-versa. So. dishoarding depends upon the rate of interest.

3. Bank credit: Another source of loanable funds is the credit created by commercial banks. Credit creation by banks increase the supply loanable funds. The loanable funds supplied by the banks also depend upon the rate of interest.

4. Disinvestment : It is also a source of loanable funds. When business is not profitable and rate of interest is high, people do not invest their money in business. They use this money for lending. This disinvestment increases the supply of loanable funds. So, disinvestment depends upon the rate of interest and profit.

Thus, the supply of loanable funds increases as rate of interest rises and vice-versa. So, the supply curve of loanable funds slopes upward from left to right.

Demand for loanable funds :

The demand for loanable funds comes mainly from three reasons. They are

1. Investment: Loanable funds are demanded for investment purposes like construction of factories and buildings. This is the most important source of demand for loanable funds. Demand tor investment purpose depends upon the rate of interest. Businessmen will demand more and invest more when the rate of interest is low and vice versa.

2. Consumption : The demand for consumption purposes is another source of demand for loanable funds. People borrow money to purchase consumption goods. They borrow only when the rate of interest is low. This demand also varies inversely with the rate of interest.

3. Hoarding : Some people may prefer to keep money in only liquid form. That is called liquidity preference. They want to hold their savings only in idle cash balances. When the rate of interest is very high, people hoard less money and vice versa.

Thus, demand for loanble funds increases when interest rates falls and falls when interest rate increases. So, the demand curve for loanable funds slopes downwards from left to right.

Determination of the rate of interest :

The rate of interest will be determined at a point where the demand for loanable funds is equal to the supply of loanable funds. The rate at which both demand for and supply of loanable funds are equal it is called equilibrium rate of Interest. This can be shown with the help of a diagram:

In the diagram SL is the total supply curve of loanable funds and DL is the total demand curve for loanable funds. They intersect each other at point E. Here the equilibrium rate of interest is OR and the demand for and supply of loanable funds are equal.

Comparison between Keynes’ Theory and Loanable Funds Theory :

Loanable funds theory is different from Keynes’ theory in the following respects:

1. Keynes considers money supply as a fixed factor. While loanable funds theory considers money as a variable factor.

2. Keynes said that money supply is not influenced by interest rate. But loanable funds theory states that money supply is influenced by the rate of interest.

3. According to Keynes, the demand for an supply of money determine the rate of interest. But according to loanable funds theory, the demand for and supply of Loanable funds determine the rate of interest.

Criticism of Loanable funds theory of interest determination:

1 . Level of Incomes: According to this theory the level of savings and investment depend upon the rate of interest. But according to Keynes, the level of savings depend not on the rate of interest but upon the level of incomes. Further more Keynes says that the level of investment depends not on the rate of interest but on the marginal efficiency of capital.

2. Full employment : Loanable funds theory is formulated assumption on full employment. But full employment is not possible in reality.

3. National Income : This theory does not take national income into consideration, According to Keynes, whenever national income changes, the supply of loanable funds also changes. Thus, he says, that it is indeterminate theory.