SESSION: 2021-22

ECONOMICS ASSIGNMENT
ON
LOANABLE FUND THEORY OF INTEREST

SUBMITTED BY :- MANISH RAJ

SUBMITTED TO :- Dr. ANJALI AGRAWAL MAM

SEMMESTER :- 1st

ROLL No. :- 21225BLT038

Serial no. Topic Page no.
1. INTRODUCTION 3

2. ASSUMPTION OF LOANBLE FUND THEORY 4

3. SUPPLY FOR LAONABLE FUND 5

4. DEMAND FOR LOANABLE FUND 6,7

5. DETERMINATION OF INTEREST 8

6. CRITICISM OF LOANABLE FUND TEORY 9,10

7. SUPERIORITY OVER THE CLASSICAL THEORY OF INTEREST 11

8. CONCLUSION 12

Introduction:-
The neo-classical theory of interest or the loanable fund theory is developed by
the neo classical economists which is an improved version of the classical
theory of interest. According to the neo-classical theory, interest is a reward for
the use of loanable funds and the rate of interest is determined by the demand
for and supply of loanable funds.

Unlike the classical theory which deals only with the real factors of saving and
investment, the loanable funds theory includes both real as well as monetary
factors influencing the loanable funds and thus the rate of interest. The loanable
funds theory was first developed by the Swedish economist K. Wicksell. Other
Swedish economists, i.e., Myrdal, Lindahl and Ohlin, and the British economist
D.H. Robertson refined the theory.

Assumptions of Neo-Classical Loanable

Funds Theory of Interest:
The loanable funds theory is based on the following assumptions:-

1. The market for loanable funds is a fully integrated market, characterised

by perfect mobility of funds throughout the market.
2. There is perfect competition in the market so that one and only one rate of
interest prevails in the market at any time.
3. Flexibility of interest rate is assumed so that it freely moves according to
the changes in the demand and supply of loanable funds.
4. The theory is stated in flow terms, considering flow of demand for and
supply of loanable funds per unit of time.
5. The theory assumes full employment of resources which implies constant
level of income and output. In other words, an increase in investment,
instead of increasing output, becomes inflationary.
6. Money is assumed to play an active role in the determination of the rate
of interest and the banks adopt a stabilizing policy with the objective to
establish monetary equilibrium.

Supply of loanable fund (LS):-

There are four sources of the supply of loanable funds:-
1. Savings (S):- Savings constitute the most important source of the supply of
loanable funds. Savings is the difference between the income and
expenditure. Since, income is assumed to remain unchanged, so the amount
of savings varies with the rate of interest. Individuals as well as business
firms will save more at a higher rate of interest and save less at a lower rate
of interest. So, there is direct relationship between the savings and rate of
interest.
2. Dishoarding (DH):- Dishoarding is another important source of the supply
of loanable funds. Generally, individuals may dishoard money from the past
hoardings at a higher rate of interest. Thus, at a higher interest rate, idle cash
balances of the past become the active balances at present and become
available for investment. If the rate of interest is low dishoarding would be
negligible.
3. Disinvestment (DI):- Disinvestment means the conversion of money
claims or securities into money or cash. This cash or money from
disinvestment used for loanable fund. If the rate of interest is high then
disinvestment is more and if rate of interest is low then disinvestment occurs
less. So, there is direct relationship between the rate of interest and
disinvestment.
4. Bank Money (BM):- Banking system constitutes another source of
the supply of loanable funds. The banks advance loans to the
businessmen through the process of credit creation. The money
created by the banks adds to the supply of loanable funds.

Demand for loanable fund:-

According to this theory demand for loanable funds arises for the following
three purposes viz.; Investment, hoarding and dissaving:-

1. Investment (I):- The main source of demand for loanable funds is the
demand for investment. Investment refers to the expenditure for the purchase of
making of new capital goods including inventories. The price of obtaining such
funds for the purpose of these investments depends on the rate of interest. An
entrepreneur while deciding upon the investment is to compare the expected
return from an investment with the rate of interest. If the rate of interest is low,
the demand for loanable funds for investment purposes will be high and If the
rate of interest is high then the demand for loanable fund for investment will be
low. This shows that there is an inverse relationship between the demands for
loanable funds for investment to the rate of interest.

2. Hoarding (H):- The demand for loanable funds is also made up by those
people who want to hoard it as idle cash balances to satisfy their desire for
liquidity. The demand for loanable funds for hoarding purpose is a decreasing
function of the rate of interest. At low rate of interest demand for loanable funds
for hoarding will be more and at high rate of interest demand for loanable funds
for hoarding will be less. So, there is indirect relationship between hoarding and
rate of interest.

3. Dissaving (DI):- Another source of demand for loanable funds comes

from dissaving, i.e., from consuming more than the current income. People tend
to borrow funds when they want to spend more than their current incomes. Such
a kind of consumption demand for loanable funds arises mostly when the
consumers decide to spend on durable goods like cars, scooters, T. V. sets, etc.
Higher the rate of interest, smaller will be dissaving or consumption demand
and lower rate of interest, higher will be dissaving demand. So, there is inverse
relationship between dissaving and rate of interest.

Determination of rate of interest:-

According to loanable funds theory, equilibrium rate of interest is that which
brings equality between the demand for and supply of loanable funds. In other
words, equilibrium interest rate is determined at a point where the demand for
loanable funds curve intersects the supply curve of loanable funds. It can be
shown with the help of a Figure 4.

The rate of interest is determined at the point of intersection of the two curves—
the supply of loanable funds curve (SL) and the demand for loanable funds
curve, DL. Fig. 4 shows that the equilibrium rate of interest is EM; at this rate,
the demand for loanable funds is equal to the supply of loanable funds i.e. OM
Criticisms the Loanable Funds Theory
of Interest:-
According to Prof. Robertson, the loanable funds theory is a “common-sense
explanation” of the determination of the rate of interest. But this theory is also
not free from certain defects.

(1) Equilibrium Rate reflects Unstable Equilibrium:

The demand and supply schedules for loanable funds determine the equilibrium
rate of interest OR which does not equate each component on the supply side
with the corresponding component on the demand side. Thus the equilibrium
rate OR reflects unstable equilibrium. For stable equilibrium, it is essential that
ex ante (planned) investment must equal ex-ante savings at the equilibrium rate
OR. In the figure, ex-ante savings S exceed ex-ante investment I by AB. They
are equal at point E1 but at a lower rate OR, which is the natural rate of interest.

(2) Indeterminate Theory:

Prof. Hansen asserts that the loanable funds theory like the classical and the
Keynesian theories of interest is indeterminate. The supply curve of loanable
funds is composed of savings, dis-hoardings and bank money. But since savings
vary with past income and the new money and activated balances with the
current income, it follows that the total supply curve of loanable funds also
varies with income. Thus the loanable funds theory is indeterminate unless the
income level is already known.
(3) Cash Balances not Elastic:

The loanable funds theory states that the supply of loanable funds can be
increased by releasing cash balances of savings and decreased by absorbing
cash balances into savings. This implies that the cash balances are fairly elastic.

But this does not seem to be a correct view because the total cash balances
available with the community are fixed and equal the total supply of money at
any time. Whenever there are variations in the cash balances, they are in fact in
the velocity of circulation of money rather than in the amount of cash balances
with the community.

(4) Savings not Interest Elastic:

The theory over-emphasises the influence of the rate of interest on savings. It

regards savings as interest elastic. Generally speaking, people save not to earn
rate of interest but to satisfy precautionary motive. So savings are interest
inelastic.

(5) Not Correct to Combine Real and Monetary Factors:

The loanable funds theory has been criticised for combining monetary factors
with real factors. It is not correct to combine real factors like saving and
investment with monetary factors like bank credit and dishoarding without
bringing in changes in the level of income. This makes the theory unrealistic.
Superiority of loanable fund theory of
interest over the classical theory of
interest:-
Despite these weaknesses, the loanable funds theory is better and more
realistic than the classical theory on a number of counts:-

1. The classical theory is a real theory of interest and neglects monetary

influences on interest. With the inclusion of real as well as monetary factors, the
loanable funds theory becomes superior to the classical theory.

2. The classicists neglect the role of bank credit as a constituent of money

supply influencing the rate of interest which is an important factor in the
loanable funds theory.

3. The classicists also do not consider the role of hoarding. By including the
desire to hoard money in the demand for loanable funds, the loanable funds
theory becomes more realistic and brings us nearer to Keynes’s liquidity
preference theory.

4. To the classicists money is merely a ‘veil,’ a passive factor influencing the

rate of interest. The loanable funds theory is superior because it regards money
as an active factor in the determination of the interest rate.
Conclusion:-
As we know that loanable fund theory of interest or neo-classical theory of
interest is used for determination of interest. It extends the classical theory,
which determined the interest rate solely by saving and investment, in that it
adds bank credit. The total amount of credit available in an economy can
exceed private saving because the bank system is in a position to create credit
out of thin air. Hence, the equilibrium (or market) interest rate is not only
influenced by the propensities to save and invest but also by the creation or
destruction of fiat money and credit.

It has many discrepancies like unstable equilibrium, indeterminate theory etc.

Despite these discrepancies, the loanable fund theory is better and more
realistic than classical theory of interest. So, we can say that loanable fund is
extended form of classical theory of interest.