The Market for Loanable Funds
Loanable funds theory has an honourable history. Over the years and across
several schools of thought, theorizing abstractly in terms of ‘loans’ was
simply a way of recognizing that the mechanisms of supply and demand
govern the intertemporal allocation of resources. The macroeconomic implications
of loanable funds theory are best seen by focusing on the resources
themselves rather than on any particular financial instrument that allows the
allocator – the entrepreneur – to take command of the resources.
People produce output in a wide variety of forms. With their incomes they
engage in consumption spending, laying claim to most but not all of the
output that they have collectively produced. The part of income not so spent,
that is, their saving, bears a strong and systematic relationship to the part of
the output that is not currently consumed. These unconsumed resources can
be made available for increasing the economy’s productive capacity. In a
market economy, there are a number of different financial instruments (bank
deposits, passbook accounts, bonds and equity shares) that transfer command
over the unconsumed resources to the business community.
The term ‘loanable funds’, then, refers summarily to all the ways that the
investment community takes command of the unconsumed resources. Further,
taking command has to include retaining command – in the case of the
undistributed earnings of the business community. Here, the business firm, in
order to expand its own productive capacity, is forgoing some market rate of
return on its retained earnings, a rate that it could have obtained through the
financial sector. For macroeconomic relevance, however, loanable funds exclude
consumer loans. Income earned by one individual and spent on
consumption either by that individual or – through saving and the consumer
loan market – by another individual is not the focus of loanable funds theorizing.
With loanable funds broadly defined to capture the variety of ways that
real investments can be financed, the corresponding interest rate that equilibrates
this market must be understood in terms that are similarly broad. A
full-bodied theory of finance would have to allow for many interest rates, the
variations among them being attributable to differences in risk, liquidity and
time to maturity. But for getting at the fundamental relationships among the
variables of capital-based macroeconomics (output, consumption, saving,
investment, and even the intertemporal pattern of resource allocation), a
summary rate is adequate. As will be noted in subsequent sections, some
considerations that account for a variation among different interest rates may
exacerbate the effects of a change in the summary rate, while other considerations
may ameliorate those effects. But in any case, the fundamental
differences that separate capital-based macroeconomics from other schools
of macroeconomics do not hinge in any important or first-order way on
relative movements of different rates of return within the financial sector.
Figure 9.5 represents the simple analytics of the loanable funds market.
The supply of loanable funds is, for the most part, saving out of current
income. In real terms, it is that part of current output not consumed. The
demand for loanable funds reflects the eagerness of the business community
to use that saving to take command of the unconsumed resources. These two
macroeconomically relevant magnitudes of saving and investment are not
definitionally the same thing but rather are brought into balance by equilibrating
movements in the broadly conceived rate of interest.
To feature the supply and demand for loanable funds in this way is only to
suggest that in a market economy the interest rate is the fundamental mechanism
through which intertemporal coordination is achieved. Simply put, the
interest rate allocates resources over time. There need be no claim here that
this Marshallian mechanism works as cleanly and as swiftly as the supply
and demand for fish at Billingsgate. Because of the elements of time and
uncertainty inherent in the intertemporal dimension of the loanable funds
market, the interest rate signal can be subject to interpretation.
What if some income is neither spent on consumption nor offered as funds
for lending? That is, what if people – unexpectedly and on an economy-wide
basis – prefer to add to their cash holdings? The increased demand for cash
holdings would constitute saving in the sense of income not consumed but
would not constitute saving in the sense of an increase in the supply of
loanable funds. One important consequence of the Keynesian revolution was
to elevate considerations of liquidity preferences to the point of dwarfing
considerations of intertemporal preferences. The rate of interest was thought
to be dominated by changes in the demand for money. Even in the counterrevolutionary
contributions of the monetarists, the interest rate was featured
on the left-hand side of the equation of exchange – as a parameter that affects
the demand for money – and not on the right-hand side as a key allocating
mechanism working within the output aggregate. (It is precisely because of
this left-handedness of its treatment of the interest rate that Milton Friedman’s
restatement of the quantity theory is taken by some scholars as a
contribution in the Keynesian tradition; see Garrison, 1992.)
The attention to the loanable funds market as depicted in Figure 9.5 reflects
the judgement of the Austrians that the rate of interest, though hidden
from view in the monetarists’ equation of exchange, is quintessentially a key
right-hand-side variable. The interest rate’s primary role in a market economy
is that of allocating investable resources in accordance with saving behaviour.
There is no denying that the interest rate can, on occasion, play a role on the
left-hand side of the equation of exchange – as a minor determinant of money
demand or as a short-run consequence of hoarding behaviour. Still, these
monetarist and Keynesian concerns are subordinate ones in the Austrians’
judgement. An exogenous change in money demand is rarely if ever the
source of a macroeconomic disruption. (Here, the Austrians fall in with the
monetarists.) And an occasional dramatic change in liquidity preference is
more likely to be a consequence of an economy-wide intertemporal coordination
failure than a cause of it. (Here, even Keynes agreed that in the context
of business cycles the scramble for liquidity is a secondary phenomenon. His
concern about the ‘fetish of liquidity’, a wholly unfounded concern in the
Austrians’ view, was spelled out in the context of long-term secular unemployment.)
Figure 9.5 (the loanable funds market) and Figure 9.1 (the Hayekian triangle)
tell the same story but at two different levels of aggregation. Figure 9.5
shows how much of the economy’s resources are available for investment
purposes. Figure 9.1 shows just how those resources are allocated throughout
the sequence of stages. A change in the interest rate, say, a reduction brought
about by an increase in saving, has systematic consequences that can be
depicted in both figures. The interest rate governs both the amount of investable
resources and the general pattern of allocation of those resources. A
rightward shift in the supply of loanable funds would move the market along
its demand curve, reducing the interest rate to reflect the increased availability
of investable resources. At the same time, that reduced rate on interest
would give a competitive edge to early-stage investment activities. Resources
available for the expansion of long-term projects come in part from the
overall increase in unconsumed resources and in part from a transfer of
resources from late-stage activities, where lower investment demand reflects
the lower demand for current and near-term output.
The effects of increased saving at both levels of aggregation are explicit in
Figure 9.4 and implicit in Figure 9.5. The change in the pattern of resource
allocation is depicted as the systematic changes in the direction and magnitude
of the stage-by-stage output levels. The increase in unconsumed resources is
depicted by the reduction in the output of goods of the first order and in the
corresponding increase in the output of second-through-tenth-order goods. And
all this is implied by a rightward shift in the supply of loanable funds: more
unconsumed resources are being allocated on the basis of lower interest rate.
What is missing in the discussion at this point is any explicit recognition of
an overall resource constraint. Scarcity is implicit in the notion that, for a
given period, output magnitudes as depicted in Figures 9.3 and 9.4 move
differentially, with some increasing and others decreasing. Early-stage activities
are expanded at the expense of current consumption and late-stage
activities. The overall resource constraint can be made explicit by the introduction
of a production possibilities frontier that makes the two-way distinction
between current consumption, which is already depicted as the vertical leg of
the Hayekian triangle, and investment, which is already being tracked along
the horizontal axis of the loanable funds diagram. A fully employed economy
can be represented as an economy producing on its production possibilities
frontier.
Loanable funds theory has an honourable history. Over the years and across
several schools of thought, theorizing abstractly in terms of ‘loans’ was
simply a way of recognizing that the mechanisms of supply and demand
govern the intertemporal allocation of resources. The macroeconomic implications
of loanable funds theory are best seen by focusing on the resources
themselves rather than on any particular financial instrument that allows the
allocator – the entrepreneur – to take command of the resources.
People produce output in a wide variety of forms. With their incomes they
engage in consumption spending, laying claim to most but not all of the
output that they have collectively produced. The part of income not so spent,
that is, their saving, bears a strong and systematic relationship to the part of
the output that is not currently consumed. These unconsumed resources can
be made available for increasing the economy’s productive capacity. In a
market economy, there are a number of different financial instruments (bank
deposits, passbook accounts, bonds and equity shares) that transfer command
over the unconsumed resources to the business community.
The term ‘loanable funds’, then, refers summarily to all the ways that the
investment community takes command of the unconsumed resources. Further,
taking command has to include retaining command – in the case of the
undistributed earnings of the business community. Here, the business firm, in
order to expand its own productive capacity, is forgoing some market rate of
return on its retained earnings, a rate that it could have obtained through the
financial sector. For macroeconomic relevance, however, loanable funds exclude
consumer loans. Income earned by one individual and spent on
consumption either by that individual or – through saving and the consumer
loan market – by another individual is not the focus of loanable funds theorizing.
With loanable funds broadly defined to capture the variety of ways that
real investments can be financed, the corresponding interest rate that equilibrates
this market must be understood in terms that are similarly broad. A
full-bodied theory of finance would have to allow for many interest rates, the
variations among them being attributable to differences in risk, liquidity and
time to maturity. But for getting at the fundamental relationships among the
variables of capital-based macroeconomics (output, consumption, saving,
investment, and even the intertemporal pattern of resource allocation), a
summary rate is adequate. As will be noted in subsequent sections, some
considerations that account for a variation among different interest rates may
exacerbate the effects of a change in the summary rate, while other considerations
may ameliorate those effects. But in any case, the fundamental
differences that separate capital-based macroeconomics from other schools
of macroeconomics do not hinge in any important or first-order way on
relative movements of different rates of return within the financial sector.
Figure 9.5 represents the simple analytics of the loanable funds market.
The supply of loanable funds is, for the most part, saving out of current
income. In real terms, it is that part of current output not consumed. The
demand for loanable funds reflects the eagerness of the business community
to use that saving to take command of the unconsumed resources. These two
macroeconomically relevant magnitudes of saving and investment are not
definitionally the same thing but rather are brought into balance by equilibrating
movements in the broadly conceived rate of interest.
To feature the supply and demand for loanable funds in this way is only to
suggest that in a market economy the interest rate is the fundamental mechanism
through which intertemporal coordination is achieved. Simply put, the
interest rate allocates resources over time. There need be no claim here that
this Marshallian mechanism works as cleanly and as swiftly as the supply
and demand for fish at Billingsgate. Because of the elements of time and
uncertainty inherent in the intertemporal dimension of the loanable funds
market, the interest rate signal can be subject to interpretation.
What if some income is neither spent on consumption nor offered as funds
for lending? That is, what if people – unexpectedly and on an economy-wide
basis – prefer to add to their cash holdings? The increased demand for cash
holdings would constitute saving in the sense of income not consumed but
would not constitute saving in the sense of an increase in the supply of
loanable funds. One important consequence of the Keynesian revolution was
to elevate considerations of liquidity preferences to the point of dwarfing
considerations of intertemporal preferences. The rate of interest was thought
to be dominated by changes in the demand for money. Even in the counterrevolutionary
contributions of the monetarists, the interest rate was featured
on the left-hand side of the equation of exchange – as a parameter that affects
the demand for money – and not on the right-hand side as a key allocating
mechanism working within the output aggregate. (It is precisely because of
this left-handedness of its treatment of the interest rate that Milton Friedman’s
restatement of the quantity theory is taken by some scholars as a
contribution in the Keynesian tradition; see Garrison, 1992.)
The attention to the loanable funds market as depicted in Figure 9.5 reflects
the judgement of the Austrians that the rate of interest, though hidden
from view in the monetarists’ equation of exchange, is quintessentially a key
right-hand-side variable. The interest rate’s primary role in a market economy
is that of allocating investable resources in accordance with saving behaviour.
There is no denying that the interest rate can, on occasion, play a role on the
left-hand side of the equation of exchange – as a minor determinant of money
demand or as a short-run consequence of hoarding behaviour. Still, these
monetarist and Keynesian concerns are subordinate ones in the Austrians’
judgement. An exogenous change in money demand is rarely if ever the
source of a macroeconomic disruption. (Here, the Austrians fall in with the
monetarists.) And an occasional dramatic change in liquidity preference is
more likely to be a consequence of an economy-wide intertemporal coordination
failure than a cause of it. (Here, even Keynes agreed that in the context
of business cycles the scramble for liquidity is a secondary phenomenon. His
concern about the ‘fetish of liquidity’, a wholly unfounded concern in the
Austrians’ view, was spelled out in the context of long-term secular unemployment.)
Figure 9.5 (the loanable funds market) and Figure 9.1 (the Hayekian triangle)
tell the same story but at two different levels of aggregation. Figure 9.5
shows how much of the economy’s resources are available for investment
purposes. Figure 9.1 shows just how those resources are allocated throughout
the sequence of stages. A change in the interest rate, say, a reduction brought
about by an increase in saving, has systematic consequences that can be
depicted in both figures. The interest rate governs both the amount of investable
resources and the general pattern of allocation of those resources. A
rightward shift in the supply of loanable funds would move the market along
its demand curve, reducing the interest rate to reflect the increased availability
of investable resources. At the same time, that reduced rate on interest
would give a competitive edge to early-stage investment activities. Resources
available for the expansion of long-term projects come in part from the
overall increase in unconsumed resources and in part from a transfer of
resources from late-stage activities, where lower investment demand reflects
the lower demand for current and near-term output.
The effects of increased saving at both levels of aggregation are explicit in
Figure 9.4 and implicit in Figure 9.5. The change in the pattern of resource
allocation is depicted as the systematic changes in the direction and magnitude
of the stage-by-stage output levels. The increase in unconsumed resources is
depicted by the reduction in the output of goods of the first order and in the
corresponding increase in the output of second-through-tenth-order goods. And
all this is implied by a rightward shift in the supply of loanable funds: more
unconsumed resources are being allocated on the basis of lower interest rate.
What is missing in the discussion at this point is any explicit recognition of
an overall resource constraint. Scarcity is implicit in the notion that, for a
given period, output magnitudes as depicted in Figures 9.3 and 9.4 move
differentially, with some increasing and others decreasing. Early-stage activities
are expanded at the expense of current consumption and late-stage
activities. The overall resource constraint can be made explicit by the introduction
of a production possibilities frontier that makes the two-way distinction
between current consumption, which is already depicted as the vertical leg of
the Hayekian triangle, and investment, which is already being tracked along
the horizontal axis of the loanable funds diagram. A fully employed economy
can be represented as an economy producing on its production possibilities
frontier.
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