Theory of Interest Loanable Funds Theory

Introduction The loanable funds theory of interest rate is an extension of the Classical theory. It incorporates non-monetary factors alongwith monetary factors of savings and investment. According to this theory rate of interest is determined by demand for and supply of loanable funds in the economy at that level in which demand and supply are equated.

Assumptions of Loanable Funds Theory: 1) Perfect mobility of funds throughout the market. 2) Perfect competition in the market, in other words both borrowers and lenders are price taker. 3) The theory uses partial equilibrium approach. The demand and supply of funds depends on the rate of interest, keeping other factors constant. 4) The theory takes flow equilibrium. 5) Money supply is exogenous.

Interest rate determination: The supply of loanable funds (LS) consists of – savings out of disposable income (S), dishoarding (DH), incremental supply of money (M*), and disinvestment (DI). LS = S + DH + M* + DI ---------- (1) LS is an increasing function of r The demand for loanable funds (LD) consists of – gross investment expenditure (I), hoarding, i.e. Incremental demand for money (MD*), and dissavings or consumption demand (DS). LD = I + MD* + DS --------------- (2) LD is a decreasing function of r. Equilibrium r will be determined at LD (r ) = LS (r ), in other words, ( I + MD* + DS ) = ( S + DH + M* + DI )

Figure-2: Interest rate determination of Loanable Funds Theory

Limitations of the Loanable Funds Theory: 1) From supply side: All savings are not routed through the loan market, some are invested directly into physical assets by households. Similarly, all dishoarding is not lent to others, some is spent directly by the dishoarders. From demand side: All investment is not financed by borrowed funds, a part of it is financed by own funds. 2) The partial equilibrium approach fails to include many variables like, real income, price, demand and supply of money, savings, investment, etc.

Continued… 3) This theory postulates that all borrowing and lending is done through perfectly homogenously bonds in one fully integrated market. This is not true even in the developed financial market. Generally there is a wide variety of loan contracts and instruments are used in several imperfectly competitive and segmented markets. 4) In the bond and securities market ‘stock equilibrium’ instead of ‘flow equilibrium’ dominates the behaviour of the rate of interest, because the volume of outstanding bonds is much more than the flow of new demand and supply of bonds during any short period.

Conclusion: The Classical theory and Neo-classical theory both are very relevant in the present context in understanding and making policy. The Monetary Approach is further improvement over the Classical theory, which is very useful in today's world. The Keynes’ Approach is also very important theory and it is the first theory which has taken Macro perspective. But the Monetary theory and Keynes’ theory will be studied at higher level. There are many theories for theory of interest, which will be studied in the future.