What is loanable funds theory?

The loanable funds theory is a neoclassical theory that determines the interest rate where the demand for loanable investments and supply of loanable funds intersect. To determine the interest rate, this theory employs linear regression and a demand curve. At the equilibrium point, demand for borrowings and demand for the issuance of borrowing funds are inextricably linked. This point of equilibrium should equalize demand and the supply of money available for borrowing.

What is the demand for loanable funds?

As per loanable funds theory, people who need loans are called borrowers. Borrowers are willing to pay a monetary price for their borrowing amount in order to obtain capital assets, working capital, new homes, and so on. According to the linear regression diagram, when the interest rate is low, the demand for borrowings is massive. According to the loanable funds theory, the following factors contribute to the need for loanable funds:

Investment

The primary source of demand for borrowing amount is the investment requisition. Investment is defined as cash spent by individuals on acquiring assets, including capital assets such as stocks. People and business organizations borrow for their personal and investment purposes. The cost of acquiring the funds is determined by the value of the investments. People weigh the return on these investments against the interest paid on borrowed funds. When the interest rate on loans falls, investment rises.

Hoarding

Hoarding also contributes to the demand for loanable funds. People want to save money for living expenses and other emergencies. They want to keep some liquid cash on hand. The demand for loanable funds for the purpose of hoarding increases when the interest rate falls.

Dissaving

Dissaving is an indirect action of savings. When people do not have any savings but their expenses have increased more than their income, they require some money to cover the additional expenses. In these circumstances, they will seek borrowings. Borrowings will increase when the interest rate is lower.

What is the supply of loanable funds?

People who save money further invest it in order to earn interest. People invest their past savings, current savings, and current earnings in order to earn additional income in the form of interest income. When the interest rate on funds falls, lenders are hesitant to issue funds for borrowings. When the interest rates increase, the supply of loanable funds will increase. The supply of loanable funds arises from the following factors:

Saving

Saving can be defined as the amount of money left over after incurring necessary expenses. People and organizations will save significantly more if they can earn a higher rate of return on their savings. It is the most significant source of supply of funds.

Dishoarding

Another important source of loan supply is dishoarding. People want to invest their savings for a higher return. When the interest rate on investments is higher investors should invest in securities, bonds, and deposits. When the rate of return is low dishoarding will be insignificant.

Disinvestment

Disinvestment is the opposite action of investment. When existing capital investments are not replaced by new investments, disinvestments are permitted. If the interest rate is higher than the earnings from current investments, disinvestment will rise. Disinvestment and interest rates are inextricably linked.

Bank credit

Bank credit creates an additional source of borrowing funds. People and organizations borrow at a fixed or variable interest rate from banks and financial institutions. Loans provided by banks and financial institutions are also included in the supply of loanable funds.

Loanable funds theory versus liquidity preference theory

The loanable funds theory encompasses a broader range of variables than the liquidity preference theory. Both theories use demand curves and linear progression to describe interest rates. Liquidity preference theory focuses solely on the money market account and the nominal interest rate that goes with it. Loanable funds theory, on the other hand, focuses not only on monetary items but also on all the monetary movements such as dishoarding, investments, and savings. Economist John Maynard Keynes proposed the liquidity preference theory. His most significant contribution was in macroeconomics. He primarily focused on liquid cash and monetary items in his liquidity preference theory.

Criticisms of loanable funds theory

According to Professor Robertson, an economist, loanable funds are a "common sense explanation" for calculating the value of the amount invested. However, there are some flaws in this classic theory.

• The demand and supply of loanable funds is used to calculate the equilibrium interest rate. But, in reality, they are not equal; they intersect at one point. As a result, the equilibrium interest rate is not a stable equilibrium.

• It is an unproven theory. The borrowing fund available for issuance is determined by people's reserves and income. Current income and savings should be added to calculate the supply of loanable funds. But the current earnings and savings could not be predicted earlier. So the interest rate is unknown.

• Loanable funds theory is based on the unrealistic assumption of full employment.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate courses and postgraduate courses and competitive exams, especially for:

• Bachelors of Commerce
• Master of Commerce
• Master of Arts in Economics
• Master of Arts in Economics

Practice Problems

Question 1: Who propound the liquidity preference theory?

   a) John Maynard Keynes

   b) Knut Wicksell

   c) None of the above

Answer: Option (a) is correct.

Explanation: Economist John Maynard Keynes suggested liquidity preference theory. His liquidity preference theory and loanable funds theory both are describing the equilibrium interest rate using a linear diagram. Liquidity preference theory only considers the money market account and interest rate associated with it. But loanable funds theory considers all the monetary movements to determine the interest rate.

Question 2: What is the root for the demand for loanable funds?

   a) Investment

   b) Savings

c) Dishoarding

Answer: Option (a) is correct.

Explanation: Demand for borrowable funds arises from investment, hoarding, dissaving sources. Investment is described as the cash spent by people on acquiring assets, capital assets. People borrow funds to invest in their business or for personal use. If the interest rate on borrowings is lesser, borrowings will increase.

Question 3: What is the root for the supply of borrowing funds?

a) Hoarding

b) Investments

c) Dishoarding

Answer: Option (c) is correct.

Explanation: Disbursement of funds available for borrowing arises from savings, disinvestment, dishoarding, and bank credit. People want to dishoard their saving amount at a greater return. At a huge interest rate, hoarders will be benefitting. If the cost of investment is low, it is not useful for fund suppliers.

Question 4: What is the assumption of loanable funds theory?

   a) Full employment

   b) Money does not act as an instrumental in determining the interest rate

   c) All of the above

Answer: Option (a) is correct.

Explanation: Loanable funds theory assumes full employment, which is the root for continuous earnings. Money is playing a vital part in identifying the interest rate. Banks and financial institutions follow a fixed policy intending to maintain monetary equilibrium.

Question 5: What is the relationship between investment and interest rate according to loanable funds theory?

   a) Direct relationship

   b) Inverse relationship

   c) None of the above

Answer: Option (b) is correct.

Explanation: There is an inverse relationship between interest rate and investments. People and business organizations borrow more for their investment and personal purposes when the interest rate is low.