The neo-classical theory of interest or loanable funds theory of interest is originated by the Swedish economist Knut Wicksell. Later on, economists like Ohlin, Myrdal, Lindahl, Robertson, and J. Viner considerably contributed to this theory.
According to this theory, the rate of interest is determined by the demand and supply of loanable funds. This theory takes into consideration both monetary factors such as hoarding and dishoarding of money and bank credit and real factors such as saving and investment. Thus, this theory is more realistic and broader than the classical theory of interest.
Demand for Loanable Funds
According to this theory demand for loanable funds is made for the following three purposes viz.; Investment, hoarding, and consumption:
The main source of demand for loanable funds is the demand for money for investment. Investment refers to the expenditure for the procurement of new capital goods including inventories. For the purpose of these investments, the price of obtaining such funds depends on the rate of interest.
An entrepreneur compares the expected return from an investment with the rate of interest while deciding upon the investment.
The lower the rate of interest, the higher will be the demand for loanable funds for investment purposes and vice-versa. This shows that there is a negative relationship between the demand for loanable funds for investment to the rate of interest.
The demand for loanable funds is made by those people who want to hoard them. The demand for loanable funds for hoarding purposes is a decreasing function of the rate of interest. At a high rate of interest demand for loanable funds for hoarding will be less and vice-versa.
When people spend beyond their current income, then they have to borrow money and thus make the demand for loanable funds. Like hoarding it is also a decreasing function of interest rate. At a high rate of interest demand for loanable funds for consumption will be less and vice-versa.
Demand for Loanable Funds = I+H+C
(Where I is Investment, H is Hoarding and C is Consumption.)
Supply of Loanable Funds
The supply of loanable funds depends upon the following sources such as savings, dishoarding, disinvestment, and bank credit:
Savings form the most important source of the supply of loanable funds. Savings is the difference between income and expenditure. Since income is assumed to be constant, the amount of savings changes with the change in the rate of interest. More savings will be made by Individuals as well as business firms at a higher rate of interest and vice-versa.
Dishoarding is another important source of the supply of loanable funds. It means that money hoarded by people is given as a loan. Generally, people may dashboard money from past hoardings at a higher rate of interest.
Thus, the past balances which were idle become the active balances at present and are hence available for investment at a higher interest rate. On the contrary, if the rate of interest is low, dishoarding will be less.
Disinvestment is the non-replacement of existing machines. It occurs when the existing capital equipment is allowed to wear out without being replaced by new capital equipment. At a higher rate of interest,
Disinvestment will be high as the present interest rate provides more returns in comparison to present earnings. On the contrary, if the rate of interest is low, disinvestment will be less.
Bank Credit (BC)
The banking system constitutes another source of the supply of loanable funds. Through the process of credit creation, the banks advance loans to businessmen. The money created by the banks adds to the supply of loanable funds. At a higher rate of interest, banks will give more credit and vice-versa.
Supply of Loanable Funds = S+DH+DI+BC
(Where S is savings, DH is dishoarding, DI is disinvestment and BC is Bank Credit.)