Loanable Fund Theory of Interest
The loanable fund theory of interest is also known as the neo-classical theory of interest. According to this theory "Interest is the reward paid to the capitalist for using loanable funds. It states that the interest roste is determined by the intersection of demand for and supply of loanable funds.
There are several sources for both demand and supply of loanable fund which are discussed below.
1. Demand for loanable
Demand for loanable funds arises for the following three propositions.
i. consumption demand (D1)
If people demand loanable funds to meet their consumption expenditure, It is called consumption demand There is a negative relationship between consumption demanded and interest rate so, the curve slopes downward.
ii. Demand of hoarding(D2)
Loanable funds are also demanded the purpose of hoarding. Hoarding means keeping wealth in liquid form (or as Idle cash).This demand for hoarding is negativly relatted to interest rate so, D3 also slopes download.
iii. Investment demand (D3)
The main source of demand for demand for lonable fund arises form investment. Low rate of interest means decrease in cost of capital. As such, there will be increase in demand for loanable fund for investment.
2.Supply of Loanable Funds (S)
There are 4 sources of supply of loanable funds.
i.Saving(S1):
Saving is the main source of loanable funds saving is the difference between income and consumption. This theory assumes that there is possitive relationship between saving and interest rate. so, curve slopes upward.
ii.Dis-Investment(S2):
Due to the lack of good opportunities for investment, people keep some part of the money to leand other people This type of money is know as disinvestment . It is possitive related to intrest rate. So, S2 curve upward.
ii.Bank (S3):
Bank money or bank credit is an important socurce of supply of loanable funds. Bank provide more funds at higher interest and less at low interest rate. Hence there is possitive relationship between bank money and interest are ao, S3 curve slopes upward.
iii.Dis-hoarding (S3):
Dishoarding means bring out horded money and marking it available for loanable purposes. At higher interst rate, people are induced to dishoarded money so that sopply of loanable funds increase. There is positive relationship between dishoarding and interest rate so,S4 curve slopes upward.
Determination of the reate of interest rate :
The determination of the rate of interest is shown graphically below.