Loanable fund theory of Interest

The Loan able fund theory of interest propounded by Swedish Economist Knut Wicksell. This theory was other Swedish economists – Gunnar Myrdal, Lindahl. And B. Ohlin and the British economist D.H. Robert sons also developed the theory in Britain.

Loan able fund theory also called new-classical theory of interest asserts that the rate of interest is determined by the equilibrium between demand and supply of loan able funds in the credit markets.

The supply of loan able funds comes from four basic sources namely, savings, dishoarding, bank credit and disinvestments. Similarly, the demand for loan able funds comes from three sources-investment consumers and hoarding (Liquidity).

Supply of Loan able Funds

Savings constitute as one of major sources of Loan able funds. Savings by individuals and households primarily depend upon the size of their incomes. But, given the level of income, saving varies at various rates of interest savings increase at the increasing rate of interest and vice visa. Saving curve is upward sloping.

(ii)        Dishoarting (DH)

Dishoarding is also another sources of supply of Loan able funds. It means bringing out hoarded money of previous periods and making it available for investment. When past hoarded amount is dishoarded the idle cash balances become active cash balances hence supply of Loan able fund will be increased. If rate of interest is high, the amount of dishoarding for the investment purpose will be increased and if the interest rate is low, the amount of dishoarding will be decreased. Hence, the dishoarding curve will be upward sloping.

(iii)      Bank Money (BM)

Bank money constitutes yet another source of loan able funds. Banks advance loans to business houses by creating credit, which is an addition to the supply of funds. Other things remaining the same, the banks have a tendency to lend more at higher rates of interest and vice-versa. Hence, Basic credit/Money curve is also upward sloping.

(iv)       Disinvestment (DI)

Loan able funds are also provided sometimes through disinvestments. It takes place when due to structured changes the existing stock of capital- equipment is allowed to weak out without being replaced. When this happens, part of the revenue from the sale of the products instead of going into capital replacement goes into the market for loan able founds. This kind of disinvestments is encouraged when the rate of interest is high in the market. So, disinvestments curve is upward sloping.

Demand for loan able funds

The demand for loan able funds comes from the following sources.

(i)         Investment

A major part of the demand for loan able funds comes from business houses, which borrow funds for various business purposes like the purchases of raw materials, capital equipments or building up inventories. If the rate of interest is low, the business houses will demand more capital (loans) to invest on above purposes. Contrarily, If the interest rate is high, the business house will demand low funds to invest on capital goods. The demand for investment is interest-elastic. So, the investment demand curve slopes downwards to the right.

(ii)        Demand for consumption (C)

Another sources of demand for Loan able funds come from consumption purpose made by consumers. People want to borrow more funds when they want to SP [end more than their current income or resources, they have. So consumers may demand more loans to spend on durable goods like television, refrigerator can motorbike, houses scooters etc. A loaner rate of interest will attract more demand of vice versa. Hence, consumption curve also called dissaving curve is downward sloping.

(iii)      Hoarding (H)

The third and last source of demand for loan able funds comes from those who want to hold idle cash balances for satisfying their desire for liquidity. If the current interest rate is high, then people will hoard less money and if the interest rate is Lord, then people will hoard more money, Due to this vision hoarding curve slopes down ward.

The total demand of loan able funds is the horizontal summation of all the above mentioned sources investment (I), Consumption (C) and hoarding (H), Similarly, total supply of loan able funds constitute all the above mentioned sources savings (S), dishoarding (DH), Bank credit (BC) and Disinvestments (DI). Hence lateral summation of all these sources is the total supply of loan able funds denoted by SL and total demand of Loan able funds is denoted by P­c

Determination of Rate of Interest

The rate of interest is determinedly the equality between demand and supply of loan able funds. This is illustrated as below.

Determination of Rate of Interest

From the above figure, it is clear that the equilibrium is attained when total demand of loan able fund and total supply of Loan able fund curve DL and SL interested at point ‘E’. Hence, the equilibrium level of interest rate is determined at or and corresponding amount of loan able funds for demand and supply simultaneously are determined at OQ level. Rate of interested and amount of demand and supply for loan able fund are measured on OY and OX across respectively.

Here, at or level of interest rate demand (OQ) and Supply (OQ) for loan able funds are equal.

Therefore, we came to know that in the worker rate of interest is determined by the intersection of demand and supply of loan able funds under loan able fund theory of interest.

Criticisms

J.M. Keynes and he’s followers have criticized this theory on the following grounds.

(1)        Assumption of full employment.

This theory is based on the full employment of resources but according to economist Keynes argued that economy is not found in a state of full employment in the real word. He argued that economy might be achieved only below the level of full-employment.

(2)        Indeterminate

According to this theory rate of interest is determined by the Loan able funds. But loan able funds depend on disposable income, which depends on investment, and ultimately it depends on the rate of interest. Hence, Prof. Hansen tells us that we trapped into vicious circle and we cannot come out of it. Hence Prof. Hanson and other economists call this theory an intermediate-theory.

(3)        Assumption of Income as Given

According to this theory, the level of income is given and fixed. Income is not influenced by the charge in the level of investment but this saying is not correct, because if rate of interest falls, the amount of investment will certainly increase and it also increases the level of income consequently.

(4)        Exaggeration of the effects of interest.

According to this theory increase in interest rate increases the level of savings. But in fact it is an exaggeration. Because if interest rate increases it is not necessary for the poor people who can save and contrary to it even at zero interest, rate rich people prefer saving their incomes. Therefore the saying that increase in the rate of interest also increase the saving may not be always true.

(5)        Inclusion of both real and monetary forces.

This theory combined the real forces and monetary forces to determine the rate of interest. But the real forces like savings and ductility of capital can’t be joined with monetary forces like bank money and liquidity preferences.

Comparison between classical theory and Loan able Theory of Interest

Loan able funds theory of interest is considered as an improvement over the classical theory of interest. The loan able fund theory of interest has tried to explain the sources of demand and supply side of loan able funds in detailed-way. Hence this theory is a superior to the classical theory. The two theories can be differentiated on the following rounds.

(1)        Explanation of read real and monetary theory

Classical theory of interest is called real theory, because this theory seeks to explain the determination of rate of interest by real factors like savings, productivity and thrift. The classical theory did not take into consideration the importance of monetary factors like cash, credit, hoardings etc while loan able fund theory of interest is real as well as monetary theory as it has given importance on the factors hoarding, disordering and bank money as well-in the determination of rate of interest.

Hence Loan able fund theory is more realistic and broader in scope as it is stated in real as well as monetary terms whose as classical theory is stated only in real terms.

(2)        Use of the term capital

According to the classical theory the rate of interest is determined by the supply of and demand for capital. But the loan able fund theory has replaced the term capital by loan able fond. Here the term ‘Loan able funds’ is wider is scope and including not only voluntary saving but also borrowed bank funds and activated idle balances. The demand for and supply of Loan able fund determine the rate of interest in the Loan able funds theory of interest.

(3)        Demand for Capital

According to the classical theory. Capital is only demand for the purpose of investment but according to Loan able fund theory the following purposes like consumption on durable goods, investment and for liquidity or dishoarding.

(4)        Supply of Capital

The classical theory has focused only to savings on the supply of capital. While the loan able funds theory of interest has given the attention on all the supply sources of loan able funds like saving, dishoarding, Bank money & disinvestments.

4 thoughts on “Loanable fund theory of Interest”

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