Also known as the neo-classical theory of interest, this theory argues that the interest rates on loans are determined by the supply of and demand for loans in the market for loanable funds. In other words, the market interest rate is seen as the price of loans and it is thought to be determined just the way the price of any other good or service is determined in the market. So, a rise in the supply of loanable funds from savers such as households is believed to cause the market interest rate to drop while a drop in the supply of loanable funds is seen as causing a rise in market interest rates. On the other hand, a rise in the demand for funds from borrowers such as businesses and governments is supposed to cause a rise in interest rates while a drop in their demand for funds is expected to cause a fall in interest rates. In short, the supply of funds from lenders and the demand for funds from borrowers are seen as influencing the market interest rate.
Interest as compensation
Loanable funds theorists argue that the interest paid on loans offers an incentive for savers to lend their money since they need to wait a certain period of time before they can get their original investment back. In other words, interest is seen as fair compensation paid to savers for waiting.
On the other hand, the rate that borrowers are willing to pay on loans is said to be determined by the return that these borrowers expect to earn by investing the borrowed funds, or the marginal productivity of capital. Finally, the market interest rate is seen as the equilibrium price that equals the supply of savings with the demand for loans in the market and which is mutually beneficial to savers and borrowers.
The loanable funds theory, which is attributed to Swedish economist Knut Wicksell, is seen as applying not just to the interest rates charged on loans. It is also said to apply to other credit transactions such as those in the bond market where businesses and governments issue bonds to borrow money from savers.
Not all economists, however, agree with the loanable funds theory of interest rates. Economists who believe in the pure time preference theory of interest, for instance, argue that the interest rate is not the price paid by borrowers for a loan but rather the price that savers actually pay for future goods or money. While this claim is quite counterintuitive, the fact that the interest rate is determined not by borrowers, but by what savers or lenders are willing to pay for future goods or money, is more obvious in the bond market than in the loan market. In the bond market, borrowers issue bonds that promise to pay a certain amount of cash over the future, and the interest rates on these bonds are determined by what lenders are willing to pay for these bonds that offer future cash flow. If the price of a bond is set too high by the bond issuers (thus yielding very little interest to lenders), then a part of the issue may be left unsold. On the other hand, if the price of a bond is set too low then the bonds may be oversold with lenders unable to buy as many bonds as they had wanted. Similarly, interest rates on bank loans are also ultimately determined by what lenders are willing to pay for future money rather than by borrowers.
It is common for many economists to believe that a high rate of interest offers more incentive for lenders to part with their money. Pure time preference theorists, however, note that strictly speaking the interest rate is not an incentive or reward for people to save and lend more. In fact, the direction of causation runs the other way round: interest rates are the result, not the cause, of the preference of people to save and invest. Hence, it would be erroneous to argue that a high rate of interest encourages people to save and lend more; a high rate of interest in a country could actually even be a sign of low confidence among people to lend their money.
It is also common to hear in the popular press that low interest rates would induce borrowers to borrow more money and thus increase demand for loans. The problem with this impression, as the pure time preference theorists argue, is that strictly speaking there really is no such thing as a demand for loans from borrowers.
As clarified earlier, what is really being sold in the market for loanable funds is the right to future money for which lenders, not borrowers, bid.