Interest Rate Determination: Loanable Funds Theory and Keynesian Theory

This section explores the determinants of interest rates, focusing on two key theories: the Loanable Funds Theory and the Keynesian Theory. We will examine how each theory explains the interaction between saving and investment in the credit market and how this interaction sets the equilibrium interest rate.

1. Loanable Funds Theory

The Loanable Funds Theory is a classical theory that explains interest rates as the equilibrium price of borrowing and lending in a market for loanable funds. It posits that the supply of loanable funds comes from saving, and the demand for loanable funds comes from investment.

1.1 Supply and Demand for Loanable Funds

The supply of loanable funds is typically represented by the national saving (S), and the demand for loanable funds is represented by the national income (Y) which is assumed to be spent on investment (I) and consumption (C): $Y = C + I + G$ (where G is government spending).

The supply curve is typically upward sloping: as the interest rate rises, the incentive to save increases, leading to a greater supply of loanable funds. The demand curve is downward sloping: as the interest rate rises, the cost of borrowing increases, discouraging investment, leading to a lower demand for loanable funds.

1.2 Equilibrium Interest Rate

The equilibrium interest rate is the rate at which the quantity of loanable funds supplied equals the quantity demanded. This intersection of the supply and demand curves determines the equilibrium interest rate.

1.3 Determinants of Supply and Demand

The Loanable Funds Theory identifies several factors that can shift the supply and demand curves for loanable funds:

• Saving: Higher national saving shifts the supply curve to the right, leading to lower equilibrium interest rates.
• Investment: Higher investment shifts the demand curve to the right, leading to higher equilibrium interest rates.
• Government Borrowing: Government borrowing shifts the demand curve to the right, leading to higher equilibrium interest rates.
• Inflation Expectations: Higher inflation expectations can increase the demand for current consumption, leading to higher investment and thus higher interest rates.
• Risk Premium: Increased risk in the economy can increase the required rate of return on investment, shifting the demand curve to the left and increasing interest rates.

Factor	Effect on Supply	Effect on Demand	Effect on Equilibrium Interest Rate
National Saving	Increase	No Change	Decrease
National Investment	No Change	Increase	Increase
Government Borrowing	No Change	Increase	Increase
Inflation Expectations	No Change	Increase	Increase
Risk Premium	No Change	Decrease	Increase

2. Keynesian Theory

The Keynesian Theory offers a different perspective on interest rate determination. It emphasizes the role of aggregate demand and the liquidity preference of individuals in determining interest rates. Keynes argued that interest rates are determined by the supply and demand for money rather than the supply and demand for loanable funds.

2.1 Supply and Demand for Money

The supply of money is controlled by the central bank (e.g., the Bank of England). The demand for money is driven by three motives:

• Transaction Motive: People hold money for everyday transactions.
• Precautionary Motive: People hold money for unexpected expenses.
• Speculative Motive: People hold money because they anticipate changes in interest rates. If interest rates are low, people expect them to rise, so they prefer to hold money. If interest rates are high, people expect them to fall, so they prefer to hold bonds.

The supply of money is generally assumed to be relatively inelastic, while the demand for money is more sensitive to changes in interest rates.

2.2 Liquidity Preference and Interest Rates

Keynes argued that individuals have a preference for holding liquid assets (money) rather than illiquid assets (bonds). This preference for liquidity is influenced by the interest rate. As the interest rate rises, the opportunity cost of holding money increases, so people are willing to hold less money and more bonds. This creates a downward-sloping demand curve for money.

2.3 Equilibrium Interest Rate

The equilibrium interest rate is the rate at which the quantity of money supplied equals the quantity demanded. This intersection of the money supply and money demand curves determines the equilibrium interest rate.

2.4 Factors Affecting Money Supply and Demand

Several factors can shift the money supply and money demand curves:

• Money Supply: Changes in the money supply (e.g., through monetary policy by the central bank) shift the supply curve for money.
• Income: Higher income generally increases the demand for money (transaction motive).
• Inflation Expectations: Higher inflation expectations can increase the demand for money (transaction motive).
• Risk and Uncertainty: Higher risk and uncertainty can increase the demand for money (precautionary motive).

3. Comparison of the Two Theories

The Loanable Funds Theory and the Keynesian Theory offer different explanations for interest rate determination. The Loanable Funds Theory focuses on the supply and demand for loanable funds, while the Keynesian Theory focuses on the supply and demand for money. Both theories provide valuable insights into how interest rates are determined in the economy.