1. The Loanable Funds Theory, also known as the “Neo-Classical Theory, ” was developed by Swedish economists like Wicksell, Bertil, Ohlin, Viner, Gunnar Myrdal and others.
2. According to this theory, interest is the price paid for the use of loanable funds.
3. The rate of interest is determined by the equilibrium between demand for and supply of loanable funds in the credit market.
Demand for Loanable Funds The demand for loanable funds depends upon the following:
1. Demand for Investment[I]
- The most important factor responsible for the loanable funds is the demand for investment.
- Bulk of the demand for loanable funds comes from business firms which borrow money for purchasing capital goods.
2. Demand for consumption[C]
- The demand for loanable funds comes from individuals who borrow money for consumption purposes also.
3. Demand for Hoarding[H]
- The next demand for loanable funds comes from hoarders. Demand for hoarding money arises because of people’s preference for liquidity, idle cash balances and so on.
- The demand for C, I and H varies inversely with interest rate.
Supply of Loanable funds: The supply of loanable funds depends upon the following four sources:
1. Savings [S]: Loanable funds comes from savings. According to this theory, savings may be of two types, namely,
- Savings planned by individuals are called “ex-ante-savings ”.
- The unplanned savings are called ‘ex-post savings”.
2. Bank Credit [BC]: The bank credit is another source of loanable funds. Commercial banks create credit and supply loanable funds to the investors.
3. Dishoarding [DH]: Dishoarding means bringing out the hoarded money into use and thus it constitutes a source of supply of loanable funds.
4. Disinvestment: [DI]: Disinvestment is the opposite of investment. Disinvestment means not providing sufficient funds for depreciation of equipment.
It gives rise to the supply of loanable funds. All the four sources of supply of loanable funds vary directly with the interest rate.
