According to the Loanable Funds Theory of Interest, the rate of interest is calculated on the basis of demand and supply of loanable funds present in the capital market. The concept formulated by Knut Wicksell, the well-known Swedish economist, is among the most important economic theories.
Basic Tenet of the Loanable Funds Theory of InterestThe Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run. On the other hand, short-term interest rates are calculated on the basis of the financial conditions of a particular economy. The determination of the interest rates in case of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts. The availability of such loan amounts is based on certain factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals.
In an attempt to develop the macro-economic theory, John Maynard Keynes studied minutely, The Demand supply interaction of Loanable funds
According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds.
Now, the demand for loanable funds is basically derived from the demand from the final goods and services. These final goods and services are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government.
The Loanable Funds Theory of the Rate of Interest has similarity with the Liquidity-Preference Theory of Interest in the sense that both of them identify the significance of the cash balance preferences and the role played by the banking sector to ensure security of the investment funds.