Loanable Funds Theory Revisited
The classical Loanable Funds Theory of interest, saving and investment enjoyed its heyday in the years before John Maynard Keynes unveiled his General Theory on the world of economics.
There is no question that Keynes contributed many new and ingenious insights into the workings of the monetary system, and the way in which investment spending and interest rates are determined, but the science was never settled and many bones of contention remain between Keynes' model and the classical school's amended version of the loanable funds model.
In this article I will present the basic loanable funds model before going on to explain the main points behind Keynes' criticisms of it, and the amendments that have been made to it. I will then provide an assessment of current thinking on the theory as well as some personal interpretation of the salient points.
Classical Supply & Demand Model of Money & Interest
In the classical model, just as in any simple supply and demand model for a normal good, the demand money for investment purposes is equated with the supply of money from savers at a market clearing rate of interest.
The downward sloping demand curve represents the demand for loanable funds (i.e. money for the purpose of investment). At higher interest rates less money is demanded since repayment costs are higher.
The real interest rate payable on a loan (i.e. the rate after adjusting for inflation) is effectively the price of the loan.
Conversely, the supply of loanable funds comes from savers, and they will happily increase that supply in return for a higher real interest rate.
Here’s the important point to remember – this classical model does not include the role of the fractional reserve banking system in the creation of credit out of thin air, i.e. regardless of the supply of money from savers, and for that reason it is an incomplete model.
Note here that I’ve merely stated that the model is incomplete, not that it is undesirable.
The classical model would be much more accurate in an economy without a fractional reserve banking system, and in an age of global debt crises there are a growing number of economists who feel that scrapping the current monetary system in favor of full reserve banking, or a sound money alternative, would be a very desirable step in the right direction.
Loanable Funds Theory Amendments
The earliest amendments to the classical model into a loanable funds doctrine that includes excess credit expansion, have been attributed to Knut Wicksell and dates back as far as the late 19th century. At that time Wicksell was attempting to explain the relationship between inflation and the rate of interest (which the classical model was failing to do).
Wicksell started with the assumption that the Quantity Theory of Money would provide an accurate account of changes in prices and interest rates in an economy where excess credit creation by the banks does not exist i.e. where the supply and demand for loanable funds is allowed to clear at a natural interest rate.
However, in a fractional reserve system such as we have today, there will be discrepancies in the gap between inflation and interest rates. In simple terms, Wicksell argues that in such a system the link between the supply and demand for loanable funds is broken, because the potential supply of credit is not limited to an equal supply of loanable funds from savers.
The Natural Rate of Interest
The implication of a fractional reserve banking system is that the only real short-term restriction on money supply growth is the ability of borrowers to pay the prevailing interest rate on credit. That interest rate may well be different to the ‘natural rate’ that would exist if the market was left to normal supply and demand forces i.e. where actual lenders' savings are matched to borrowers' investments.
This link between savings and investment loans is broken in a banking sector that can create an extra supply of loanable funds via credit expansion alone, without any associated increase in savings.
To the extent that the prevailing interest rate is below the natural rate, this would be consistent with the banks boosting credit levels such that borrowing exceeds saving. In these circumstances it is likely that malinvestment will occur whereby poor investments, with returns lower than would be necessary to pay the natural rate of interest, are routinely being made.
The end result of this will be a boom-bust business cycle, because spending in the economy will outpace the growth of productive capacity i.e. it leads to rising prices followed by recession. In extreme circumstances, such as those in 2022, the real interest rate (after accounting for inflation) can go negative for a prolonged period of time if the government intervenes in the market to keep nominal rates low.
How is the Interest Rate Determined?
The interest rate is determined by the supply of, and the demand for, money. However, money in this context can take the form of credit that has been created by the banks. It is not necessary for savings to equal borrowing, and that breaks the classical model of interest rate determination.
The loanable funds doctrine seeks to amend the classical model by including the impact of credit creation by the banking system.
The problem with the prevailing rate of interest is that it is divorced from the natural rate that occurs when the supply of, and demand for, loanable funds is allowed to clear by itself. It invariably leads to excess supply of credit and fuels economic instability via an exacerbated business cycle.
In reality, interest rates that solely reflect the demand for money/credit offer a much better model of the loanable funds market than the unamended classical model.