Money and Banking

Interest Rate Determination: Loanable Funds Theory and Keynesian Theory

1. Loanable Funds Theory

The loanable funds theory explains how the equilibrium interest rate is determined by the supply and demand for loanable funds in the economy.

Supply of Loanable Funds: This represents the amount of savings available for lending. It is typically determined by the level of income and the propensity to save.

Demand for Loanable Funds: This represents the amount of funds businesses and consumers need to borrow for investment and consumption. It is typically determined by the level of investment and government borrowing.

The intersection of the supply and demand curves determines the equilibrium interest rate.

Factor	Effect on Supply of Loanable Funds	Effect on Demand for Loanable Funds	Effect on Equilibrium Interest Rate
Income (Y)	Increases	Increases	No definite effect (could increase or decrease depending on the relative shifts)
Propensity to Save (1-MPC)	Increases	No definite effect	Decreases
Government Borrowing	Decreases	Increases	No definite effect (could increase or decrease depending on the relative shifts)

2. Keynesian Theory

Keynesian theory argues that interest rates are determined by the supply and demand for money, rather than the supply and demand for loanable funds. The demand for money is influenced by transaction, precautionary, and speculative motives.

Demand for Money: This is typically represented by the quantity of money demanded at different interest rates. The demand curve is generally downward sloping.

Supply of Money: This is controlled by the central bank (e.g., the Bank of England) and is assumed to be fixed for the purpose of this analysis.

The equilibrium interest rate is determined where the quantity of money supplied equals the quantity of money demanded.

Factors Affecting the Demand for Money:

• Transaction Demand: The demand for money to facilitate day-to-day transactions. This is positively related to income.
• Precautionary Demand: The demand for money to cover unexpected expenses. This is also positively related to income.
• Speculative Demand: The demand for money as a store of value. This is inversely related to the interest rate. Higher interest rates mean people prefer to hold less money.

The Liquidity Trap: A situation where increasing the money supply further does not lower interest rates because people prefer to hold onto cash due to pessimism about the future.