Question

What is meant by Determination of Rate of Interest in Economics? Define.

What do you understand by Loanable Funds Theory of Interest? What are the criticism of Loanable Funds Theory of Interest?

How rate of interest determined through loanable funds? Explain.

 

Answer 1

DETERMINATION  OF RATE OF INTEREST -

There are several theories which analyse the process of interest rate determination. Like; 

1.  Classical Theory of Interest Rate Determination 

2.  Loanable Funds Theory 

3.  Keynesian Liquidity Preference Theory 

4.  IS-LM Theory of Interest 

 

Loanable Funds Theory -

The Loanable Funds Theory was developed by the neo-classical economists. The main contributors in the development of this theory were Knut Wicksell, Bertil Ohlin, Myrdal and Robertson.

The main drawback of the classical saving-investment theory was that, interest rate was supposed to be dependent on only two factors. The neo-classical economists, thought that there are other factors also which should be taken into account for interest rate determination.

It was said that interest rate is the price of lending and borrowing and, therefore, it is dependent on the demand and supply of funds available for lending i.e. Loanable Funds. We must, therefore, identify and understand various factors which affect demand and supply of loanable funds. According to the neo-classical economists the demand and supply of loanable funds is dependent on the following factors.

 

Demand for Loanable Funds -

The demand for loanable funds means that money which is demanded as borrowing and for which the borrower is prepared to pay interest. Naturally, there is an inverse relationship between the rate of interest and the demand for loanable funds. Loanable funds are demanded for the following purposes.

(1) Investment (I) Loanable funds are demanded for investment purpose. Investment refers to purchase of capital assets, from which profit can be earned in future. This is the most important demand factor.

(2) Consumption (C) Apart from investment, funds are also demanded for consumption, including expenditure on illness, education, marriages, purchase of durable consumer goods or other important purposes.

(3) Hoarding (H) People have a tendency to hoard the loanable funds in the form of cash. The objective of this hoarding is to keep ready cash for some important objective or for any contingent purpose.

In this way, the funds demanded for the above purposes is dependent on rate of interest. At a high rate less is demanded and at a low rate of interest more funds are demanded.

 

Supply of Loanable Funds -

There are following sources of supply of loanable funds.

(1) Saving (S) The main source of supply of loanable funds is saving. Saving means the amount of money left after meeting current consumption out of current income. It is believed that if the rate of interest in high, there will be greater motivation for saving and consequently the amount of savings will increase. In this way, a positive relationship is assumed between the rate of interest and amount of savings.

(2) Bank-Money(BM) we all know that commercial banks create credit. This credit is the purchasing power or the money which the banks give on credit to different persons, firms or companies. Hence, this is also an important source of supply of loanable funds. It also has a positive relation with rate of interest.

(3) Dishoarding (DH) Dishoarding refers to taking out the hoarded money and using it for giving loans to other. Since it meets the borrowing needs of the people, it is also a source of loanable funds. At high rates of interest more dishoarding is done and vice versa.

(4) Disinvestment(DI) Disinvestment means sale of capital assets. When interest rate rises and capital assets also do not yield high income, then investors dispose off their capital assets and use the funds so received for lending. In this way supply of loanable funds increase. If a firms does not make enough provision for depreciation, this also result in disinvestment, because the replacement of assests is not done and the amount of investment decreases.

 

Interest Rate Determination through Loanable Funds -

In this way, we find that there are several sources of demand and supply of loanable funds. If we add the different sources of demand we get ‘Aggregate Demand for Loanable Funds (ADLF) and when we add different sources of supply, we get ‘Aggregate Supply of Loanable Funds (ASLF) and accordingly rate of interest is determined.

 

Criticism of Loanable Funds Theory -

Although, the lonable funds theory was considered an improvement over the classical theory, still the following criticisms of this theory have been given.

(i)  In this theory, savings have been considered to be dependent on rate of interest, but it is not so. Savings is determined primarily by income. The impact of rate of interest is only negligible.

(ii)  Similarly, the amount of investment is also not much affected by interest rate but by marginal efficiency of capital or rate of return. These factors have not been considered in this theory.

(iii)  In this theory, real factors like savings, investment have been mixed with monetary factors like bank money and hoarding. This also is not logical.

(iv)  This theory is called indeterminate, because saving, investment, consumption etc. which determine interest rate are themselves dependent on income. However, level of income itself is dependent on rate of interest. Hence, rate of interest is not independently determined in this theory and that is why this is considered an indeterminate theory.

 

 

 

 

 

 

 

The Loanable Funds Theory was developed by the neo-classical economists. The main contributors in the development of this theory were Knut Wicksell, Bertil Ohlin, Myrdal and Robertson.