In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the interest rate is determined by the demand for and supply of loanable funds. The term loanable funds includes all forms of credit, such as loans, bonds, or savings deposits.
Economics is the social science that studies the production, distribution, and consumption of goods and services.
The loanable funds doctrine was formulated in the 1930s by British economist Dennis Robertson [1] and Swedish economist Bertil Ohlin. [2] However, Ohlin attributed its origin to Swedish economist Knut Wicksell [3] and the so-called Stockholm school, which included economists Erik Lindahl and Gunnar Myrdal. [4]
Sir Dennis Holme Robertson was an English economist who taught at Cambridge and London Universities.
Bertil Gotthard Ohlin was a Swedish economist and politician. He was a professor of economics at the Stockholm School of Economics from 1929 to 1965. He was also leader of the People's Party, a social-liberal party which at the time was the largest party in opposition to the governing Social Democratic Party, from 1944 to 1967. He served briefly as Minister for Trade from 1944 to 1945 in the Swedish coalition government during World War II. He was President of the Nordic Council in 1959 and 1964.
Johan Gustaf Knut Wicksell was a leading Swedish economist of the Stockholm school. His economic contributions would influence both the Keynesian and Austrian schools of economic thought. He was married to the noted feminist Anna Bugge.
The loanable funds doctrine extends the classical theory, which determined the interest rate solely by saving and investment, in that it adds bank credit. The total amount of credit available in an economy can exceed private saving because the bank system is in a position to create credit out of thin air. Hence, the equilibrium (or market) interest rate is not only influenced by the propensities to save and invest but also by the creation or destruction of fiat money and credit.
If the bank system enhances credit, it will at least temporarily diminish the market interest rate below the natural rate. Wicksell had defined the natural rate as that interest rate which is compatible with a stable price level. Credit creation and credit destruction induce changes in the price level and in the level of economic activity. This is referred to as Wicksell's cumulative process.
According to Ohlin (op. cit., p. 222), one cannot say "that the rate of interest equalises planned savings and planned investment, for it obviously does not do that. How, then, is the height of the interest rate determined. The answer is that the rate of interest is simply the price of credit, and that it is therefore governed by the supply of and demand for credit. The banking system – through its ability to give credit – can influence, and to some extent does affect, the interest level."
In formal terms, the loanable funds doctrine determines the market interest rate through the following equilibrium condition:
where denote the price level, real saving, and real investment, respectively, while denotes changes in bank credit. Saving and investment are multiplied by the price level in order to obtain monetary variables, because credit comes also in monetary terms.
In a fiat money system, bank credit creation equals money creation, Therefore, it is also common to represent the loanable funds doctrine as The preceding description holds for closed economies. In open economies, net capital outflows must be added to credit demand.
Net capital outflow (NCO) is the net flow of funds being invested abroad by a country during a certain period of time. A positive NCO means that the country invests outside more than the world invests in it. NCO is one of two major ways of characterizing the nature of a country's financial and economic interaction with the other parts of the world.
In classical theory, the interest rate i is determined by saving and investment alone: Changes in the quantity of money do not affect the interest rate but only influence the price level (as per the quantity theory of money).
In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.
Keynesian liquidity preference theory determines interest and income using two separate equilibrium conditions, namely, the equality of saving and investment, and the equality of money demand and money supply, This is the familiar IS-LM model. Like the classical approach, the IS-LM model contains an equilibrium condition that equates saving and investment.
In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.
The loanable funds doctrine, by contrast, does not equate saving and investment, both understood in an ex ante sense, but integrates bank credit creation into this equilibrium condition. According to Ohlin: "There is a credit market ... but there is no such market for savings and no price of savings". [5] An extension of bank credit reduces the interest rate in the same way as an increase in saving.
During the 1930s, and again during the 1950s, the relationship between the loanable funds doctrine and the liquidity preference theory was discussed at length. Some authors considered the two approaches as largely equivalent [6] but this issue is still unresolved.
While the scholarly literature uses the term loanable funds doctrine in the sense defined above, [7] [8] textbook authors [9] and bloggers [10] sometimes refer colloquially to "loanable funds" in connection with classical interest theory. This ambiguous use disregards the characteristic feature of the loanable funds doctrine, namely, its integration of bank credit into the theory of interest rate determination.
The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.
Interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum, at a particular rate. It is distinct from a fee which the borrower may pay the lender or some third party. It is also distinct from dividend which is paid by a company to its shareholders (owners) from its profit or reserve, but not at a particular rate decided beforehand, rather on a pro rata basis as a share in the reward gained by risk taking entrepreneurs when the revenue earned exceeds the total costs.
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.
The Stockholm School, is a school of economic thought. It refers to a loosely organized group of Swedish economists that worked together, in Stockholm, Sweden primarily in the 1930s.
The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.
In macroeconomics, Aggregate Demand (AD) or Domestic Final Demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amounts of goods and services that will be purchased at all possible price levels.
Irving Fisher was an American economist, statistician, inventor, and Progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt deflation has been embraced by the Post-Keynesian school. Joseph Schumpeter described him as "the greatest economist the United States has ever produced", an assessment later repeated by James Tobin and Milton Friedman.
James Edward Meade, was a British economist and winner of the 1977 Nobel Memorial Prize in Economic Sciences jointly with the Swedish economist Bertil Ohlin for their "pathbreaking contribution to the theory of international trade and international capital movements."
In economics, crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.
Monetary disequilibrium theory is a product of the monetarist school and is mainly represented in the works of Leland Yeager and Austrian macroeconomics. The basic concepts of monetary equilibrium and disequilibrium were, however, defined in terms of an individual's demand for cash balance by Mises (1912) in his Theory of Money and Credit.
The paradox of thrift is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving. The paradox is, narrowly speaking, that total saving may fall because of individuals' attempts to increase their saving, and, broadly speaking, that increase in saving may be harmful to an economy. Both the narrow and broad claims are paradoxical within the assumption underlying the fallacy of composition, namely that what is true of the parts must be true of the whole. The narrow claim transparently contradicts this assumption, and the broad one does so by implication, because while individual thrift is generally averred to be good for the economy, the paradox of thrift holds that collective thrift may be bad for the economy.
The Harrod–Domar model is a classical Keynesian model of economic growth. It is used in development economics to explain an economy's growth rate in terms of the level of saving and productivity of capital. It suggests that there is no natural reason for an economy to have balanced growth. The model was developed independently by Roy F. Harrod in 1939, and Evsey Domar in 1946, although a similar model had been proposed by Gustav Cassel in 1924. The Harrod–Domar model was the precursor to the exogenous growth model.
The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
Credit rationing is the limiting by lenders of the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about equilibrium in the market. It should not be confused with cases where credit is simply "too expensive" for some borrowers, that is, situations where the interest rate is deemed too high. With credit rationing, the borrower would like to acquire the funds at the current rates, and the imperfection is the absence of equilibrium in spite of willing borrowers. In other words, at the prevailing market interest rate, demand exceeds supply, but lenders are not willing to either loan more funds, or raise the interest rate charged, as they are already maximising profits.
Initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities.
A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments.
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.
Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.
Cumulative process is a contribution to the economic theory of interest, proposed in Knut Wicksell's 1898 work, Interest and Prices. Wicksell made a key distinction between the natural rate of interest and the money rate of interest. The money rate of interest, to Wicksell, is the interest rate seen in the capital market; the natural rate of interest is the interest rate at which supply and demand in the market for goods are in equilibrium – as though there were no need for capital markets.
