Loanable funds: Meaning, Criticisms & Real-World Uses

What Is Loanable Funds?

Loanable funds refer to the total amount of money available in an economy for lending and borrowing. It is a fundamental concept within macroeconomics that explains how interest rates are determined by the interaction of the demand and supply of these funds. In essence, the market for loanable funds brings together those who want to save and those who wish to borrow for investment or consumption. The equilibrium interest rate is established where the quantity of loanable funds supplied equals the quantity demanded.

The term "loanable funds" encompasses various forms of credit, including loans, bonds, and savings deposits. This concept is crucial for understanding how financial markets facilitate the flow of capital from savers to borrowers, impacting overall economic growth and activity.

History and Origin

The conceptualization of loanable funds as a determinant of interest rates evolved from classical economic thought. The loanable funds doctrine, as a more comprehensive theory, was notably formulated in the 1930s by British economist Dennis Robertson and Swedish economist Bertil Ohlin. Ohlin, however, attributed its intellectual origins to an earlier Swedish economist, Knut Wicksell, and the Stockholm school of economic thought, which included Erik Lindahl and Gunnar Myrdal.⁵

This theory extended the classical view, which primarily considered savings and investment as the sole determinants of interest rates, by incorporating additional factors such as bank credit and the desire to hold money (hoarding). By acknowledging the role of monetary factors alongside real factors, the loanable funds theory provided a more robust framework for analyzing the forces that influence the cost of borrowing and the return on savings in an economy.

Key Takeaways

The loanable funds theory explains how the market interest rates are determined by the interaction of the supply and demand for funds available for lending.
The supply of loanable funds primarily comes from private savings, public savings (government budget surpluses), and bank credit creation.
The demand for loanable funds largely originates from private investment (firms borrowing for capital goods), household borrowing for consumption (e.g., mortgages), and government borrowing (to finance a budget deficit).
The equilibrium interest rate is the rate at which the quantity of funds supplied by lenders matches the quantity of funds demanded by borrowers.
Changes in factors affecting either the supply or demand for loanable funds will lead to a shift in the interest rate, which in turn influences investment, consumption, and overall economic activity.

Formula and Calculation

The market for loanable funds can be represented by the interaction of supply and demand curves. While there isn't a single, universal formula, the equilibrium condition is met when the quantity of loanable funds supplied equals the quantity demanded.

The supply of loanable funds ($S_{LF}$) can be expressed as:

S_{LF} = S_P + S_G + S_F + BC

Where:

(S_P) = Private savings (from households and firms)
(S_G) = Government savings (budget surplus)
(S_F) = Foreign savings (net capital inflow)
(BC) = Bank credit creation

The demand for loanable funds ($D_{LF}$) can be expressed as:

D_{LF} = I + G_{Def} + C_{Cons} + H

Where:

(I) = Investment (by firms for capital goods)
(G_{Def}) = Government borrowing (to finance a budget deficit)
(C_{Cons}) = Household borrowing for consumption
(H) = Hoarding (demand to hold money as idle balances)

The equilibrium interest rate ((r^*)) is determined where:

S_{LF} = D_{LF}

S_P + S_G + S_F + BC = I + G_{Def} + C_{Cons} + H

This equation illustrates how the forces contributing to the availability of funds interact with the forces driving the need for funds to establish the prevailing interest rate in the financial markets.

Interpreting the Loanable Funds

Interpreting the concept of loanable funds involves understanding how shifts in its supply and demand influence interest rates and, consequently, economic activity. An increase in the supply of loanable funds, perhaps due to higher national savings or expansionary monetary policy by central banks, tends to lower interest rates. Lower interest rates typically encourage more borrowing for investment and consumption, stimulating economic growth.

Conversely, an increase in the demand for loanable funds, such as a large government budget deficit or a surge in corporate investment opportunities, would exert upward pressure on interest rates. Higher interest rates can make borrowing more expensive, potentially curbing investment and consumption. Therefore, analyzing the trends in savings, investment, government fiscal policy, and monetary policy provides insights into the future direction of interest rates and their macroeconomic implications.

Hypothetical Example

Consider a hypothetical economy, Econoland. The initial equilibrium interest rate in Econoland is 5%.

Suppose the government of Econoland announces a new infrastructure program that will cost $200 billion, to be financed entirely by borrowing from the public, leading to a significant budget deficit. This action increases the government's demand for loanable funds.

Before the government's announcement, the market for loanable funds was balanced at the 5% interest rate. With the new demand for $200 billion, the total demand for loanable funds at the 5% interest rate now exceeds the available supply. To attract the necessary funds, the government and other borrowers must offer higher interest rates. As interest rates rise, more individuals and institutions are incentivized to increase their savings, thereby increasing the supply of loanable funds. Simultaneously, some private investment projects that were viable at 5% may no longer be profitable at higher rates, causing private demand for funds to decrease.

This process continues until a new, higher equilibrium interest rate is reached—say, 6.5%—where the increased supply of funds (from both domestic and foreign sources, as well as reduced private demand) matches the new, higher total demand for loanable funds.

Practical Applications

The concept of loanable funds is widely applied in various areas of economics and finance:

Monetary Policy: Central banks utilize the loanable funds framework to understand how their actions influence interest rates. For instance, an expansionary monetary policy, such as open market purchases, increases the supply of reserves in the banking system, which in turn increases the supply of loanable funds and tends to lower interest rates. Conversely, a contractionary monetary policy reduces the supply of loanable funds, leading to higher interest rates.
⁴ Fiscal Policy Analysis: Governments analyze the market for loanable funds when determining the impact of their borrowing on the economy. A persistent budget deficit increases the demand for loanable funds, potentially leading to higher interest rates and "crowding out" private investment.
Forecasting Interest Rates: Economists and financial analysts use the supply and demand dynamics of loanable funds to forecast future movements in interest rates, which is critical for bond markets, corporate finance, and personal financial planning.
Global Capital Flows: The theory can be extended to international financial markets to explain how cross-border flows of savings and investment influence global interest rates. For example, a global increase in savings relative to investment demand can contribute to a decline in real interest rates worldwide.
³ Understanding Economic Cycles: Shifts in the supply or demand for loanable funds can signal potential changes in economic growth and inflationary pressures, helping policymakers anticipate and respond to business cycles, including periods of recession or overheating.

Limitations and Criticisms

While the loanable funds theory offers a robust framework for understanding interest rates, it is not without its limitations and criticisms. One of the most prominent critiques comes from the Keynesian school of thought, particularly regarding the role of money supply and liquidity preference.

Keynesian economists argue that the loanable funds theory overemphasizes the role of savings and investment as the primary determinants of interest rates, overlooking the crucial impact of monetary factors and the demand for money as a store of value. John Maynard Keynes posited that interest rates are fundamentally a monetary phenomenon, determined by the supply and demand for money itself, not just the flow of funds for investment. He argued that saving has no special efficacy in "releasing cash and restoring liquidity" and that what drives interest rates is a desire to hold money balances. Cri²tics suggest that the theory can sometimes imply a direct causal link from savings to investment that may not fully capture the complexities of a modern economy where banks can create credit independently of pre-existing savings.

Fu¹rthermore, the theory sometimes faces criticism for simplifying the behavior of market participants and the role of central banks in setting short-term interest rate targets, which can influence longer-term rates. While the theory considers bank credit creation as a source of supply, some critics argue it doesn't adequately account for the endogenous nature of money creation in a fractional reserve banking system.

Loanable Funds vs. Liquidity Preference Theory

The loanable funds theory and the liquidity preference theory both seek to explain the determination of the interest rate but differ in their emphasis and underlying assumptions.

The loanable funds theory focuses on the real aspects of the economy, asserting that the interest rate is determined by the intersection of the supply of funds available for lending (primarily from savings, bank credit creation, and government surpluses) and the demand for funds (for investment, consumption, and government deficits). It views the interest rate as the price of credit that equilibrates the flow of funds between lenders and borrowers over a period.

In contrast, the liquidity preference theory, developed by John Maynard Keynes, views the interest rate as the price for parting with liquidity, or the reward for not hoarding money. This theory emphasizes the role of the existing stock of money and the public's desire to hold wealth in liquid form (cash) versus less liquid forms (bonds). It posits that the interest rate is determined by the supply of money (controlled by the central bank) and the public's demand for money, driven by transactional, precautionary, and speculative motives. The key difference lies in whether the interest rate is seen as a reward for saving (loanable funds) or a reward for surrendering liquidity (liquidity preference).

FAQs

What are the main sources of supply for loanable funds?

The primary sources of supply for loanable funds include household savings, business retained earnings, government budget surpluses (public saving), net capital inflows from abroad (foreign saving), and the creation of new credit by the banking system.

Who demands loanable funds?

The main entities demanding loanable funds are firms seeking financing for new investment in capital goods, households borrowing for large purchases like homes or cars, and governments financing budget deficits through debt issuance. Additionally, individuals or entities may demand funds for hoarding (holding idle cash balances).

How does monetary policy affect loanable funds?

Monetary policy, typically conducted by a central bank, directly influences the supply of loanable funds. For example, by purchasing government bonds in open market operations, the central bank injects money into the banking system, increasing bank reserves and thus expanding the supply of loanable funds. This typically leads to lower interest rates. Conversely, selling bonds reduces the supply of loanable funds, pushing interest rates higher.

What is the role of the interest rate in the loanable funds market?

The interest rate acts as the price in the market for loanable funds. It adjusts to bring the quantity of funds that lenders are willing to supply into equilibrium with the quantity of funds that borrowers are willing to demand. A higher interest rate incentivizes more saving and deters borrowing, while a lower rate encourages borrowing and may reduce saving.