Question

Explain the impact that loanable funds theory has on interest rates.

Answer 1

Loanable funds theory determines the equilibrium interest rates based on demand and supply of the loanable funds. According to this theory, the demand for loanable funds arises from dissaving, hoarding and investments whereas the supply of loanable funds arises from savings, dishoarding, bank money, and disinvestment. The loanable funds' theory brings in an equilibrium between demand and supply of loanable funds by equating the demand of loanable funds with the supply of loanable funds. The equilibrium is established by setting up an interest rate. When the demand for loanable funds increases, this theory increases the interest rate and when the demand decreases it decreases the interest rate. On the other hand, when the supply of loanable funds increases, it decreases the interest rate and vice versa.