Loanable Funds
The loanable funds theory explains the determination of the interest rate through the supply of and demand for funds available for lending. The supply of loanable funds comes from saving, from the creation of money by the banking system, and from any other sources of funds, while the demand comes from borrowing for investment, for consumption, and for government deficits. The interest rate adjusts to equate the supply and demand for funds, and the theory provides a framework for analysing the effects of changes in saving, investment, and fiscal policy on interest rates and on the allocation of credit.
Supply of funds
The supply of loanable funds is derived from the decisions of households, firms, and others to save rather than to consume. Saving is the portion of income not spent, and it is supplied to the market in return for interest. The supply of funds therefore increases with the interest rate, because a higher return makes saving more attractive, and it depends on income, on preferences for present versus future consumption, and on the distribution of income.
The supply is augmented by the creation of credit by banks, which expands the funds available for lending beyond the amount of prior saving, and by inflows of foreign capital. Foreign saving increases the supply of funds available in a country with an open capital account, and it can lower domestic interest rates and finance investment or consumption. The composition and stability of the supply of funds matter for the behaviour of interest rates and for the allocation of credit.
Demand for funds
The demand for loanable funds comes from borrowers who wish to finance investment, consumption, or government spending. Firms borrow to invest in capital, and the demand for such funds is inversely related to the interest rate, because a higher rate raises the cost of capital and reduces the profitability of investment projects. Households borrow to finance housing and durable goods, and governments borrow to finance deficits.
The demand for funds therefore depends on the profitability of investment opportunities, on the cost of capital, on the demand for housing and consumer credit, and on the fiscal position of the government. It is inversely related to the interest rate, so that the demand curve slopes downward, and shifts in any of its determinants move the curve and change the equilibrium rate.
Determination of the interest rate
The intersection of the supply and demand for loanable funds determines the equilibrium interest rate, at which the quantity of funds supplied equals the quantity demanded. At a higher rate, the supply exceeds the demand, and the rate falls; at a lower rate, the demand exceeds the supply, and the rate rises. The framework therefore explains the level of the interest rate as the price that balances saving and investment.
The framework is used to analyse the effects of changes in its determinants. An increase in the demand for funds, for example from a rise in investment opportunities or from a larger government deficit, raises the interest rate. An increase in the supply, for example from higher saving, lowers it. The effects on investment and on growth depend on the response of borrowing to the interest rate, and on the extent to which the supply of funds is elastic.
Relationship to monetary policy
The loanable funds framework and the monetary approach to interest rates are two perspectives on the same phenomenon, and they can be reconciled. In the loanable funds view, the interest rate is determined by the real flows of saving and investment, and monetary policy affects it indirectly by influencing income and prices. In the monetary view, the interest rate is determined by the supply and demand for money, and the central bank can influence it directly. The two views emphasise different channels and different time horizons.
The reconciliation is that the interest rate must clear both markets, and that monetary and fiscal policy influence the outcome through both. Central bank operations affect the supply of funds and the demand for money, while fiscal policy affects the demand for funds. The framework therefore provides a bridge between the analysis of real saving and investment and the analysis of monetary conditions, and it helps to explain how policy affects interest rates and the allocation of credit.
Criticisms and extensions
The theory has been criticised for assuming that the interest rate is determined solely by the flow of funds in each period, without sufficient attention to stocks and to expectations. Modern analyses incorporate the stock of assets and liabilities, the role of expectations about future rates and inflation, and the effects of risk and liquidity on the required return. The distinction between real and nominal rates, and the role of inflation expectations, is also central.
Extensions incorporate foreign capital flows, the role of financial intermediaries and their willingness to lend, and the effects of regulation and of risk on the supply of credit. These extensions help to explain why interest rates can diverge from the level implied by domestic saving and investment, and why the availability of credit, and not only its price, matters for investment and growth. The loanable funds framework remains a useful starting point for analysing these questions.
The real interest rate and the classical view
The loanable funds framework is associated with the classical view that the interest rate is determined by real factors, namely saving and investment, and that it adjusts to equate the two. In this view, the interest rate is the price of present goods in terms of future goods, and it reflects the productivity of capital and the time preference of households. Monetary factors affect the price level and nominal rates, but the real rate is determined by real forces.
The classical view contrasts with the Keynesian view, in which the interest rate is determined by liquidity preference and the money supply, and in which saving and investment are equalised through changes in income rather than through the interest rate. The two views emphasise different mechanisms and different time horizons, and their reconciliation is that the interest rate must clear both the market for funds and the market for money, and that the adjustment of income links the two.
Open economy and international capital flows
In an open economy, the supply of loanable funds includes saving from abroad, and the demand includes investment by foreign residents. International capital flows allow the domestic interest rate to differ from the world rate only to the extent permitted by frictions, and in a small open economy with perfect capital mobility, the domestic rate is tied to the world rate. Domestic saving and investment need not be equal, because the difference is financed by foreign capital or lent abroad.
This openness changes the effects of policies. A fiscal expansion that raises domestic demand for funds may attract capital from abroad rather than raising the domestic interest rate, and it may appreciate the currency and worsen the trade balance. The effects on investment depend on the response of capital flows and on the exchange rate regime, and they illustrate how openness modifies the analysis of saving and investment and of the crowding-out of private activity.
Financial intermediation and credit conditions
The loanable funds framework focuses on the flow of funds, but modern analysis emphasises the role of financial intermediaries and of credit conditions. Banks and other intermediaries screen borrowers, monitor them, and transform maturities, and their willingness to lend affects the availability of credit independently of the interest rate. During periods of stress, institutions may tighten standards and ration credit, so that borrowers cannot obtain funds even at prevailing rates.
This recognition has implications for policy. It implies that the availability of credit, and not only its price, matters for investment, and that policies that support the capitalisation and liquidity of financial institutions can affect investment and growth. It also implies that central bank operations affect the economy partly through their effect on the supply of credit, and that the analysis of loanable funds must be supplemented by attention to the behaviour of intermediaries and to the structure of the financial system.