Interest: Loanable Funds Theory of Interest

Interest

Interest is what the borrower pays the lender in exchange for the loaned funds. It is stated as a percentage per year. For instance, if someone borrows Rs. 100 today and promises to pay back Rs. 115 after a year, the fee (interest for the usage of the amount borrowed) is Rs. 15. Therefore, interest is the sum that represents the difference between the amount borrowed and the amount that is agreed to be returned after a certain amount of time.

Gross Interest and Net Interest

Gross interest is the amount paid by a borrower to a lender for a borrowed sum of money after a predetermined amount of time. Gross interest, then, is the sum that a borrower pays to a lender as a return on the capital borrowed. The cost of the loan, return for inconveniences, and other costs are all included in gross interest in addition to the payment for the use of the money. The cost incurred just for the use of the capital is known as net interest. Net interest, then, is the sum paid only for the use of capital.

The Loanable Funds Theory of Interest Rates

Knut Wicksell, a Swedish economist, developed this hypothesis. Later, this idea was improved by other Swedish economists as G. Myrdal, Lindahl, and B. Ohlin. The classical theory of interest is improved by this idea. Because it considers both monetary and real elements in determining the interest rate, this theory is more comprehensive than the traditional theory of interest.

Swedish economist Knut Wicksell developed this hypothesis. Later, economists from Sweden including B. Ohlin, G. Myrdal, and Lindahl improved this hypothesis. The classical theory of interest has been improved by this hypothesis. Because both monetary and real factors are taken into account in determining the interest rate, this theory is more comprehensive than the traditional theory of interest.

Assumptions of the loanable fund's theory of interest

The idea of interest for the loanable fund is predicated on the following simplifications:

• The loanable funds market is a completely integrated market that is distinguished by perfect fund mobility across the market.
• Since there is complete market rivalry, only one rate of interest has market dominance.
• The assumption is that the rate of interest will fluctuate freely in response to shifts in the supply and demand for loanable money.

Demand for Loanable Funds

There are three reasons why there is a need for loanable funds:

Investment demand: The primary demand for loanable funds comes from this area. Investments include the creation of new inventories as well as the production of new capital goods. To buy capital equipment, raw materials, or to increase inventories, businesses need money. Interest elasticity governs investment demand for loanable money.

Dissaving: Dissaving, or spending more than one's current income allows, is another source of demand for loanable funds. For the purchase of durable consumer products like cars, scooters, TVs, and other items, consumers want loanable finances. These loans are also flexible in terms of interest.

Hoarding: Loanable money is also needed for stockpiling. Hoarding is the practice of holding onto money or liquid assets. Any sort of wealth can be simply converted into cash. People typically store cash in order to satiate their need for liquidity. This has elastic interest as well.

Supply of Loanable Funds

There are four sources of loanable money:

Saving: The main sources of loanable cash are savings by individuals or businesses. The portion of money that is saved and not used for spending. The rate of interest and savings have a favorable association.

Dishoarding: This is an additional source of creditable money. It entails releasing hidden funds and making them available for lending purposes. People tend to hoard money when interest rates are low in order to satisfy their need for liquidity and are dissuaded from lending, and the opposite is also true.

Bank money: The supply of loanable cash comes from the money in the banks. Banks create credit to extend loans. The amount of loanable cash increases as a result of the banks' money creation. The bank offers flexible interest rates.

Disinvestment: Additionally, it is a significant source of the money that can be borrowed. It entails not giving enough money for depreciation, which implies allowing the current machinery to wear out without being replaced.

Determination of Equilibrium Rate of Interest

The demand for the loanable funds curve DD1 and the supply of the loanable funds curve SS1 interact to produce the interest rate shown in the figure. The curves of investment (I), consumption (C), and sand hoarding are lateral summed to get the overall demand curve for loanable money (DD1) (H). The demand for loanable money rises as the rate of interest decreases, as seen by the downward slope of the DD1 curve to the right. Similar to the total supply curve for loanable funds, the curves for saving (S), bank money (Bc), disinvestment (DI), and dishoarding (SS1) are horizontally summed to produce the SS1 curve (DH). The bigger supply of loanable funds grows with increases in the rate of interest, as seen by the upward slope of the SS1 curve to the right. The point E where the total demand curve DD1 and the total supply curve SS1 cross is the equilibrium interest rate. The supply and demand for loanable funds are equal to OM at the equilibrium rate of interest, Or.

Criticisms

The loanable funds are really a modified version of the conventional theory of interest, not a brand-new idea. It can therefore be criticized in the same ways that the conventional theory can. The following are the theory's main flaws

• According to this hypothesis, changes in investment have no impact on the level of income, which is assumed to remain constant. But in the actual economy, this is incorrect.
• The full employment premise underlies the loanable money idea. Keynes disputed this notion, claiming that it could only happen in an exceptional economic condition.

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan