Critically analyze the Loanable Fund Theory of interest.

Interest is the payment a borrower makes to a lender for the use of capital. The loanable funds theory was proposed by the Swedish economist Knut Wicksell and refined by Ohlin, Lindahl and Myrdal. It states that the rate of interest is determined where the demand for loanable funds equals the supply of loanable funds. Unlike the classical theory, it includes both real factors (saving and investment) and monetary factors (hoarding and bank credit).

The assumptions of the theory are:

1. Perfect competition in the capital market.
2. Perfect mobility of funds between borrowers and lenders.
3. Full employment of resources.
4. Flexible interest rate, which adjusts freely.
5. Money plays an active role in determining the rate of interest.

Demand for loanable funds: all these sources slope downward, because demand varies inversely with the interest rate.

1. Consumption: loans to buy durable goods such as refrigerators, televisions and cars. A lower interest rate leads to more borrowing.
2. Investment: borrowing to build new capital goods and inventories. A lower interest rate leads to more investment.
3. Hoarding: holding idle cash to take advantage of future changes in interest rates or security prices. A lower interest rate leads to more hoarding.

Supply of loanable funds: all these sources slope upward, because supply varies directly with the interest rate.

1. Saving: household and corporate savings are the main source. A higher interest rate leads to more saving.
2. Disinvestment: firms release depreciation reserves and working capital into the market. A higher interest rate leads to more disinvestment.
3. Dishoarding and bank money: idle cash becomes active, and banks lend more through credit creation. Both rise as the interest rate rises.

Determination of the interest rate:

The total demand curve (D = consumption + investment + hoarding) slopes downward, and the total supply curve (S = saving + disinvestment + dishoarding + bank money) slopes upward. The equilibrium interest rate Or is set at E, where they intersect, and the equilibrium quantity of loanable funds is OQ. If the interest rate is above Or, supply exceeds demand and the rate falls. If it is below Or, demand exceeds supply and the rate rises. In Nepal, for example, when banks raise deposit rates households save more, and when loan rates fall businesses borrow more to invest. These two forces together set the market rate.

(In the figure, C = consumption, I = investment, H = hoarding, S = saving, DI = disinvestment, DH = dishoarding and BM = bank money.)

Merits:

More realistic than the classical theory: it includes monetary factors such as hoarding, dishoarding and bank credit alongside real factors such as saving and investment, giving a more complete explanation of interest.

Criticisms:

Unrealistic assumptions and indeterminacy:
a. Full employment and a constant level of income do not hold in the real world.
b. The theory is circular: the supply of loanable funds depends on income, income depends on investment, and investment depends on the interest rate. Because income is unknown, the interest rate cannot be determined.
c. It combines monetary factors (hoarding, bank money) and real factors (saving, investment), which differ in origin, nature and impact, so the combination is not fully realistic.

Over-emphasis on the interest rate: in practice, saving depends more on the size of income than on the interest rate. Investment depends more on the marginal efficiency of capital, expected demand and taxation than on the interest rate alone.

The loanable funds theory improves on the classical theory by adding monetary factors, and it explains that interest is set where the demand for and supply of loanable funds are equal. However, because of its unrealistic assumptions and indeterminacy, it does not give a complete explanation, which led Keynes to propose the liquidity preference theory.