Loanable Funds Theory: Interest Rate Determination

Loanable Funds Theory of Interest Rate

The Loanable Funds Theory of Interest is also known as the Neo-Classical Theory of Interest. It was developed by economists Knut Wicksell, Bertil Ohlin, Gunnar Myrdal, and Professor Dennis Robertson. This theory explains the determination of the rate of interest with the help of both real and monetary forces. According to Prof. Robertson, "Interest is the price which equates the demand for and supply of loanable funds."

Meaning of Loanable Funds Theory

The loanable funds theory explains that the interest rate is determined by the forces of demand for loanable funds (from investors, consumers, and hoarders) and supply of loanable funds (from savings, bank credit, dishoarding, and disinvestment). Thus, interest becomes the price paid for borrowing loanable funds.

Explanation of the Theory

Supply of Loanable Funds

The supply of loanable funds in the economy comes from four major sources:

1. Savings (S): Savings form the most important source of supply of loanable funds. Savings are done by households and the government when income exceeds expenditure. Savings increase when the rate of interest is high, as people are encouraged to save more. Thus, saving is a direct function of the rate of interest: S = f(ROI).
2. Bank Credit (BC): Banks create credit and provide loans to individuals and businesses. When the interest rate is high, banks are encouraged to lend more as they earn higher returns, thereby increasing the supply of loanable funds. Thus, bank credit is positively related to the rate of interest.
3. Dishoarding (DH): Dishoarding refers to releasing or lending money which was previously hoarded or kept idle. When the interest rate increases, people are motivated to lend out their idle money to earn interest, resulting in dishoarding. Thus, dishoarding rises with an increase in the rate of interest: DH = f(ROI).
4. Disinvestment (DI): Disinvestment means withdrawing money from existing capital or assets and lending it instead. When the interest rate is high, people prefer to lend money instead of investing in assets which yield lower returns. Thus, disinvestment is also directly related to the interest rate.