Loanable funds theory (Neo – classical theory) of Interest:
The loanable funds theory was introduced by Knut Wicksell, Dennis Robertson and others. The loanable funds theory is broader in its scope than the classical theory of interest. The word “loanable funds” comprises not only saving out of current income however also bank credit, dishoarding and dis-investments. However by saving, the classical economists termed only to saving out of present income. We know now that bank credit is a significant source of funds for the investment.
In classical theory, saving was demanded just for investment. However according to loanable funds theory, the demand for funds occur, not only for investment however also for hoarding wealth.
The classical theory considered interest as a function of saving and investment, (i.e., r = f (S.I.). However, according to loanable funds theory, the rate of interest is a function of four variables, that is,
r = f (1,S M.L.) Here,
r is the rate of interest, I = investment, S = saving, M = bank credit andL = desire to hoard or the desire for liquidity.
Figure: Diagrammatic example of Loanable funds theory of interest
In figure above the Curve ‘S’ symbolizes savings, the curve ‘M’ symbolizes bank credit (involving dishoarded and disinvested wealth). The curve S + M symbolizes total loanable funds at various rates of interest.
On demand side, the curve I symbolizes demand for investment. The curve L symbolizes demand for idle cash balances or to hoard money. The curve I + L symbolize the net demand for loanable funds at distinct rates of interest. The market rate of interest rm is determined by the intersection of S + M curve and I + L curve. The aggregate demand for loanable funds is equivalent to the aggregate supply of loanable funds at this rate of interest. In classical theory, rn that might be termed as the natural rate of interest is determined by the intersection of I and S curves. That is, whenever the rate of interest is rn, the demand for investment is equivalent to the supply of savings.Criticism:
1) There is no doubt which loanable fund theory is an enhancement over the classical theory of interest. It has been condemned on the ground which it supposes that saving is a function of the rate of interest;
2. It ignores persuade of changes in the level of investment on employment, income and on savings.
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