Model Answer
0 min readIntroduction
The determination of the rate of interest is a fundamental concept in macroeconomics, with various theories attempting to explain its mechanics. Among the prominent ones are the Classical Theory and the Loanable Funds Theory. While the Classical Theory, largely a product of 18th and 19th-century economists, posited interest as a purely 'real' phenomenon determined by saving and investment, the Loanable Funds Theory emerged as a neo-classical refinement. Developed by economists like Knut Wicksell, Ohlin, and Robertson, this theory offers a broader and more realistic perspective by integrating both real and monetary factors in determining the equilibrium interest rate, thereby establishing its superiority.
Understanding the Classical Theory of Interest
The Classical Theory of Interest views the interest rate as the price paid for the use of capital, determined by the interaction of the supply of savings and the demand for investment. It is inherently a 'real' theory, meaning it focuses on physical resources and productivity rather than monetary aspects. According to this theory, saving is a function of the interest rate (higher interest incentivizes more saving), and investment is also a function of the interest rate (lower interest encourages more investment).
- Supply of Capital (Savings): Derived from abstinence from present consumption. Higher interest rates encourage more saving.
- Demand for Capital (Investment): Arises from the marginal productivity of capital. Lower interest rates make more investment projects profitable.
- Equilibrium: The interest rate is determined where savings equal investment (S=I).
- Assumptions: Full employment, perfect competition, and money serving only as a medium of exchange (a "veil").
Limitations of the Classical Theory
Despite its foundational contribution, the Classical Theory faces several criticisms, leading to its perceived inadequacy in explaining real-world interest rate determination:
- Assumption of Full Employment: It assumes full employment, which is rarely observed in real economies. In situations of unemployment, the reward for abstaining from consumption (saving) is less relevant.
- Neglect of Monetary Factors: It completely ignores the role of money, monetary policy, and credit creation by banks, considering money as merely a medium of exchange.
- Indeterminacy: Critics argue that the theory is indeterminate. Saving depends on income, investment depends on interest, and income itself depends on investment. Without knowing income, saving cannot be determined, creating a circular problem.
- Narrow View of Supply and Demand: It considers only current savings as the supply of capital and only productive investment as the demand. It overlooks other sources and demands for funds.
The Loanable Funds Theory of Interest
The Loanable Funds Theory, also known as the Neo-Classical Theory of Interest, broadens the scope by considering both real and monetary factors in the determination of the interest rate. It posits that the interest rate is determined by the demand for and supply of "loanable funds" in the market. Loanable funds encompass all types of credit, including loans, bonds, and savings deposits.
Components of Demand for Loanable Funds:
- Investment (I): The primary demand for loanable funds comes from businesses and individuals seeking to finance capital projects. This demand is inversely related to the interest rate.
- Hoarding (H): Demand for idle cash balances or liquidity preference. At lower interest rates, people prefer to hoard more money.
- Dissaving (DS): When individuals or entities spend more than their current income, they may borrow, creating a demand for funds.
Components of Supply of Loanable Funds:
- Savings (S): This includes household, business, and government savings. Higher interest rates generally encourage more saving.
- Bank Credit (BM): Funds created by commercial banks through their lending activities. This is a crucial monetary factor absent in the classical theory.
- Dishording (DH): Release of previously hoarded money back into the market.
The equilibrium interest rate is determined where the total demand for loanable funds (I + H + DS) equals the total supply of loanable funds (S + BM + DH).
Superiority of the Loanable Funds Theory
The Loanable Funds Theory is generally considered superior to the Classical Theory due to its more comprehensive and realistic approach to interest rate determination. The key aspects of its superiority are:
1. Broader Scope and Inclusivity of Factors
Unlike the classical theory's narrow focus on real factors (saving and investment), the loanable funds theory integrates both real and monetary factors. It acknowledges the role of bank credit creation and hoarding/dishoarding, providing a more complete picture of the financial market.
2. Recognition of Monetary Influence
The Loanable Funds Theory explicitly incorporates the role of money supply and bank credit, which are vital in modern economies. Central banks' monetary policies, such as adjusting the repo rate, directly influence the supply of loanable funds and thus the interest rate. For instance, the Reserve Bank of India (RBI) frequently adjusts its repo rate to manage liquidity and inflation.
3. More Realistic Demand and Supply Sides
The theory expands the sources of demand beyond just investment to include hoarding and dissaving. Similarly, the supply of funds includes not only current savings but also dishoarding and newly created bank credit. This makes the model more aligned with actual financial market dynamics.
4. Addressing the Indeterminacy Problem (Partially)
While some critics argue that the Loanable Funds Theory still suffers from a degree of indeterminacy, it offers a more robust framework than the Classical Theory. By incorporating changes in the money supply and liquidity preferences, it better explains how interest rates adjust even when income levels are not constant.
5. Explaining Short-term and Long-term Rates
The Loanable Funds Theory is better equipped to explain both short-term fluctuations and long-term trends in interest rates as it considers the dynamic interplay of various factors that can shift demand and supply curves for loanable funds. The classical theory, being more static, struggles with this.
| Feature | Classical Theory of Interest | Loanable Funds Theory of Interest |
|---|---|---|
| Determinants of Interest Rate | Purely real factors: Savings (S) and Investment (I) | Both real and monetary factors: Savings (S), Bank Credit (BM), Dishoarding (DH), Investment (I), Hoarding (H), Dissaving (DS) |
| Role of Money | Neutral; a "veil" over real transactions. No independent role in interest rate determination. | Active; bank credit and hoarding are integral components, influenced by monetary policy. |
| Sources of Supply of Funds | Only current savings (S) | Current savings (S), Bank Credit (BM), Dishoarding (DH) |
| Sources of Demand for Funds | Only investment demand (I) | Investment demand (I), Hoarding (H), Dissaving (DS) |
| Assumption | Full employment, static analysis | More realistic, considers varying levels of employment, dynamic analysis. |
| Criticism | Indeterminacy, neglects monetary factors, unrealistic assumptions. | Also faces some criticism regarding indeterminacy, but to a lesser extent than classical. |
Conclusion
In conclusion, while the Classical Theory laid the groundwork for understanding interest rates, its limitations, particularly the neglect of monetary factors and the unrealistic assumption of full employment, rendered it less applicable to modern economies. The Loanable Funds Theory, by incorporating both real and monetary aspects such as bank credit, hoarding, and dissaving, offers a far more comprehensive and pragmatic framework for analyzing interest rate determination. Its ability to reflect the complexities of financial markets and the influence of monetary policy makes it demonstrably superior in explaining how interest rates are established in an economy.
Answer Length
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