Loanable funds theory (Neo -
classical theory) of Interest
The loanable funds theory was developed by Knut Wicksell,
Dennis Robertson and others. The loanable funds theory is wider in its scope
than the classical theory of interest. The term 'loanable funds' includes not
only saving out of current income but also bank credit, dishoarding and
disinvestments. But by saving, the classical economists referred only to saving
out of current income. We know now that bank credit is an important source of
funds for investment.
In the classical theory, saving was demanded only for
investment. But according to loanable funds theory, the demand for funds arose,
not only for investment but also for hoarding wealth.
The classical theory regarded interest as a function of
saving and investment, (r = f (S.I.) But, according to loanable funds theory,
the rate of interest is a function of four variables, i.e r = f (1,S M.L.)
where r is the rate of interest, I = investment, S = saving, M = bank credit
and L = desire to hoard or the desire for liquidity.
In
Fig. The Curve 'S' represents savings, the curve 'M' represents bank credit
(including dishoarded and disinvested wealth). The curve S + M represents total
loanable funds at different rates of interest.
On the demand side, the curve I represents demand for
investment. The curve L represents demand for idle cash balances or to hoard
money. The curve I + L represents the total demand for loanable funds at
different rates of interest. The market rate of interest rm is determined by
the intersection of S + M curve and I + L curve. The aggregate demand for
loanable funds is equal to the aggregate supply of loanable funds at this rate
of interest. In the classical theory, rn which may be called the natural rate
of interest is determined by the intersection of I and S curves. That is, when
the rate of interest is rn, the demand for investment is equal to the supply of
savings.