LOANABLE FUND THEORY – ALL YOU NEED TO KNOW
The loanable funds theory describes the ideal interest rate for loans as the point in which the supply of loanable funds intersects with the demand for loanable funds. Under this theory, the loanable funds market is evaluated by building on a classical market analysis, with loanable funds acting as the “product” and the real interest rate (the interest rate after accounting for inflation) acting as the “price”.
According to the loanable fund theory , the rate of interest is determined by the supply and demand of loans .The supply of loans is from the saving funds of public special institutions like banks, co-operative societies and private money-lenders. These institutions collect the small surplus funds from various individuals and by keeping a small portion from the total as liquid, the rest of the fund is given as loan on long term to the borrowers . The difference between the rates of interest of creditors and borrowers of such institutions denotes their profit. The supply side of loans also includes people who dishoard money or those who save of current income or those whose set apart funds depreciation.
On demand side of loans, we have people demanding loans for hoarding, for destructing credit, for meeting repairs, renewals and depreciation and for net investment.
The loanable fund theory is an all-inclusive theory and hence, it is difficult to find out important factors determining the rate of interest at any one time. The demand and supply of loans can be determined only when income is known and the theory does not determine income, it becomes necessary to assume the level of income in this theory.
The theory is based on the following simplifying assumptions:
- That the market for loanable funds is one fully integrated (and not segmented) market, characterised by perfect mobility of funds throughout the market;
- That there is perfect competition in the market, so that each borrower and lender is a ‘price-taker’ and one and only one pure rate of interest prevails in the market at any time. The forces of competition are also supposed to clear the market pretty fast, so that the single rate of interest is the market-clearing (or the equilibrium) rate of interest.
The theory uses partial-equilibrium approach in which all factors other than the rate of interest that might influence the demand or supply of loanable funds are assumed to be held constant. In other Words, it assumes that the rate of interest does not interact with other macro variables.
In its popular form, the theory is stated, in ‘flow’ terms, considering flow demand and supply of funds per unit time. As such, ‘he theory hypothesises that it is the ‘flow equilibrium’ (or the equilibrium between two flows) of loanable funds which determines ‘he rate of interest.
Given the above assumptions, the determination of r is easily explained, once the demand and supply of loanable funds is specified.
This is where the loanable-funds theory is claimed to be an improvement over the classical savings and investment theory of r, since, besides the real factors of savings and investment, it also takes into account the monetary factors of hoarding, dishoarding, and increase in money supply in the determination of r. In this sense it combines both the monetary and non-monetary factors.
Demand for loanable funds
According to the loanable funds definition, the people who “demand” loans are the borrowers. Borrowers are willing to pay interest rates in order to secure assets in the form of business opportunities, houses, etc.
On the line graph, the demand for loanable funds line slopes downward. When the real interest rate is high, borrowers are not motivated to take out loans, and thus the quantity of loanable funds remains low. However, if the real interest rate is low, there’s plenty of incentive for borrowers to take out loans, so the demand for loanable funds is high.