In this article we will discuss about the loanable funds theory of interest with its criticisms.
The neo-classical or the loanable funds theory explains the determination of interest in terms of demand and supply of loanable funds or credit. According to this theory, the rate of interest is the price of credit, which is determined by the demand and supply for loanable funds.
In the words of Prof. Lerner, it is the price which equates the supply of ‘credit’, or saving plus the net increase in the amount of money in a period, to the demand for ‘credit’, or investment plus net hoarding “in the period.”
Let us analyse the forces behind the demand and supply of loanable funds:
Demand for Loanable Funds:
The demand for loanable funds has primarily three sources i.e., government, businessmen and consumers who need them for purposes of investment, hoarding and consumption. The government borrows funds for constructing public works or for war preparations.
The businessmen borrow for the purchase of capital goods and for starting investment projects. Such borrowings are interest elastic and depend mostly on the expected rate of profit as compared with the rate of interest.
The demand for loanable funds on the part of consumers is for the purchase of durable consumer goods like scooters, houses, etc. Individual borrowings are also interest elastic. The tendency to borrow is more at a lower rate of interest than at a higher rate in order to enjoy their consumption soon. Since this demand for funds is mostly met out of past savings or through dis-saving, it is represented by the curve Ds in Figure 2.
The demand curve for investment funds, both for the government and the businessmen is shown as curve I. It slopes downward showing that less funds are borrowed at a higher rate and more at a lower rate of interest.
Lastly, funds are demanded for the purpose of hoarding them in liquid form or as idle cash. They are also interest elastic and are shown by the curve H. The lateral summation of these curves H, Ds and 1 gives us the aggregate demand curve for loanable funds SD.
Supply of Loanable Funds:
The supply of loanable funds comes from savings, dis-hoardings and bank credit. Private, individual and g corporate savings are the main source of savings. Though personal savings depend upon the income level, yet taking the level of income as given they are regarded as interest elastic.
The higher the rate of interest, the greater will be the inducement to save and vice versa. Corporate savings are the undistributed profits of a firm which also depend on the current rate of interest to some extent. If the interest rate is high, it will act as a deterrent to borrowing and thus encourage savings. Savings are indicated as curve S in the Figure 2.
The second source is the volume of funds coming out of hoards or being added to them. Dishoarding may represent not only purchase of old assets or securities from others out of idle cash balances of one’s own funds for net investment or for consumption in purchases in excess of net disposable income. Such funds are directly related to the rate of interest.
The higher the interest rate the larger the funds that will be coming out of hoards and vice versa. These funds are represented by the curve Dh. Lastly, there is the bank credit as an important source of the supply of loanable funds.
Bank credit or money is also interest elastic to some extent. More funds are lent at a higher than at a lower rate of interest. Bank credit is shown as the curve M. If these curves DH, M and S are laterally added up, we have the aggregate supply curve SS of loanable funds.
The total demand curve for loanable funds SD and the total supply curve of loanable funds SS intersect at E and give OR rate of interest. At this rate OQ amount of funds are borrowed and lent.
Criticisms the Loanable Funds Theory of Interest:
According to Prof. Robertson, the loanable funds theory is a “commonsense explanation” of the determination of the rate of interest. But this theory is also not free from certain defects.
(1) Equilibrium Rate reflects Unstable Equilibrium:
The demand and supply schedules for loanable funds determine the equilibrium rate of interest OR which does not equate each component on the supply side with the corresponding component on the demand side. Thus the equilibrium rate OR reflects unstable equilibrium. For stable equilibrium, it is essential that ex ante (planned) investment must equal ex-ante savings at the equilibrium rate OR. In the figure, exante savings S exceed ex-ante investment I by AB. They are equal at point E1 but at a lower rate OR, which is the natural rate of interest.
(2) Indeterminate Theory:
Prof. Hansen asserts that the loanable funds theory like the classical and the Keynesian theories of interest is indeterminate. The supply curve of loanable funds is composed of savings, dis-hoardings and bank money. But since savings vary with past income and the new money and activated balances with the current income, it follows that the total supply curve of loanable funds also varies with income. Thus the loanable funds theory is indeterminate unless the income level is already known.
(3) Cash Balances not Elastic:
The loanable funds theory states that the supply of loanable funds can be increased by releasing cash balances of savings and decreased by absorbing cash balances into savings. This implies that the cash balances are fairly elastic.
But this does not seem to be a correct view because the total cash balances available with the community are fixed and equal the total supply of money at any time. Whenever there are variations in the cash balances, they are in fact in the velocity of circulation of money rather than in the amount of cash balances with the community.
(4) Savings not Interest Elastic:
The theory over-emphasises the influence of the rate of interest on savings. It regards savings as interest elastic. Generally speaking, people save not to earn rate of interest but to satisfy precautionary motive. So savings are interest inelastic.
(5) Not Correct to Combine Real and Monetary Factors:
The loanable funds theory has been criticised for combining monetary factors with real factors. It is not correct to combine real factors like saving and investment with monetary factors like bank credit and dishoarding without bringing in changes in the level of income. This makes the theory unrealistic.
Its Superiority over the Classical Theory:
Despite these weaknesses, the loanable funds theory is better and more realistic than the classical theory on a number of counts.
1. The classical theory is a real theory of interest and neglects monetary influences on interest. With the inclusion of real as well as monetary factors, the loanable funds theory becomes superior to the classical theory.
2. The classicists neglect the role of bank credit as a constituent of money supply influencing the rate of interest which is an important factor in the loanable funds theory.
3. The classicists also do not consider the role of hoarding. By including the desire to hoard money in the demand for loanable funds, the loanable funds theory becomes more realistic and brings us nearer to Keynes’s liquidity preference theory.
4. To the classicists money is merely a ‘veil,’ a passive factor influencing the rate of interest. The loanable funds theory is superior because it regards money as an active factor in the determination of the interest rate.