The Loanable Funds Theory of Rate of Interest, also known as the Neo-Classical theory, is an improvement over the classical theory. It was developed by economists like Wicksell, Ohlin, and Robertson. Unlike the classical theory, it considers both real and monetary factors in determining the rate of interest. According to this theory, interest is determined by the demand and supply of loanable funds in the capital market.
Loanable funds refer to the total amount of funds available for lending in the economy. These funds come from savings, dishoarding, and bank credit. Similarly, these funds are demanded for investment, consumption, and hoarding purposes.
The supply of loanable funds consists of the following components:
The supply of loanable funds increases with a rise in the rate of interest, hence the supply curve slopes upward.
The demand for loanable funds includes:
The demand for loanable funds decreases with a rise in the rate of interest, hence the demand curve slopes downward.
According to the loanable funds theory, the rate of interest is determined by the equilibrium between the supply and demand for loanable funds.
Supply of loanable funds includes savings, dishoarding, and bank credit, while demand consists of investment, consumption, and hoarding. The equilibrium rate of interest is determined at the point where total supply equals total demand.
If the rate of interest is above equilibrium, supply of funds will exceed demand, leading to a fall in interest rate. On the other hand, if the rate of interest is below equilibrium, demand for funds will exceed supply, causing the interest rate to rise. Thus, equilibrium is restored automatically.
This theory is more realistic than the classical theory as it incorporates monetary factors like bank credit and hoarding along with real factors like savings and investment.
Equilibrium occurs where Demand = Supply of Loanable Funds
The loanable funds theory provides a more comprehensive explanation of interest rate determination by including both real and monetary factors. However, despite its improvements over the classical theory, it still has certain limitations and was later refined by Keynesian theory.