Question

Elucidate the Loanable Funds Theory of Interest.

Answer 1

1. The loanable fund's theory, also known as the “Neoclassical theory”. This theory was developed by Swedish economists like Wicksell, Bertilohlin, Viner, Gunnar Myrdal, and others.
2. Interest is the price paid for the use of loanable funds.
3. The rate of interest is determined by the equilibrium between the demand for and supply of loanable funds in the credit market.

Demand for loanable funds:

1. Demand for Investment (I)
2. Demand for Consumption (C)
3. Demand for Hoarding (H)

Supply of loanable funds:

• Savings (S):
  

Savings may be of two types, namely.

1. Savings planned by individuals are “ex-ante savings”. (Eg.) LIC premium
2. Unplanned savings are called “ex-post savings”

• Bank credit:
  Commercial banks create credit and supply loan-able funds to the investors.
• Dishoarding (DH):
  Dishoarding means bringing out the hoarded money into use and thus it constitutes a source of supply of loanable funds.
• Disinvestment (DI):
  Disinvestment is the opposite of investment. It means not providing sufficient funds for the depreciation of equipment.
• Equilibrium:
  The rate of interest is determined by the equilibrium between the total demand for and the total supply of loanable funds.
  Supply of loanable funds = S + BC + DH + DI
  Demand for loanable funds = I + C + H
  
• Explanation:
  The X-axis represents the demand for and supply of loanable funds, Y-axis represents the rate of interest. The LS curve represents the total supply curve of loanable funds. The LD curve represents the total demand for loanable funds. The LD and LS curves, intersect each other at the point “E” the equilibrium point. At this point OR rate of interest and OM is the number of loanable funds.
• Criticisms:

1. 1. Many factors have been included in this theory’. Still, there are many more factors like
      • Asymmetric information
      • Moral Hazard.
   2. It is very difficult to combine real factors with monetary factors.