According to the loanable-funds theory, the rate of interest is determined by the demand for and the supply of funds in the economy at that level at which the two (demand and supply) are equated. Thus, it is a standard demand-supply theory as applied to the market for loanable funds (credit), treating the rate of interest as the price (per unit time) of such funds.
The theory is based on the following simplifying assumptions:
1. That the market for loanable funds is one fully integrated (and not segmented) market, characterised by perfect mobility of funds throughout the market;
2. That there is perfect competition in the market, so that each borrower and lender is a ‘price-taker’ and one and only one pure rate of interest prevails in the market at any time. The forces of competition are also supposed to clear the market pretty fast, so that the single rate of interest is the market-clearing (or the equilibrium) rate of interest.
The theory uses partial-equilibrium approach in which all factors other than the rate of interest that might influence the demand or supply of loanable funds are assumed to be held constant. In other Words, it assumes that the rate of interest does not interact with other macro variables.
In its popular form, the theory is stated, in ‘flow’ terms, considering flow demand and supply of funds per unit time. As such, ‘he theory hypothesises that it is the ‘flow equilibrium’ (or the equilibrium between two flows) of loanable funds which determines ‘he rate of interest.
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