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THE LOANBLE FUNDS THEORY OF REAL INTEREST RATES

The central theoretical explanation of real interest is known as the loanable funds theory. According to the loanable funds theory, the principal decision faced by economic agents is how to make the best use of the resources available to them over their lifetimes. One way of increasing one’s future real standard of living is to borrow funds in order to take advantage of investment opportunities in the economy. The real rate of interest borrowers are willing to pay should thus be determined in general by the real rate of return available on capital. In a perfect market this is equal to the marginal productivity of capital – the addition to output that results from a one-unit addition to capital, on the assumption that nothing else changes. This is influenced by factors such as the rate of invention and innovation of new products and processes, improvements in the quality of the workforce, and the ability to reorganize the economy to make better use of scarce resources.
    Savers, on the other hand, are able to increase their future consumption levels by forgoing some consumption in the present and lending funds to investors. We start by assuming that consumers would, other things being equal, prefer to consume all of their income in the present. They are only prepared to save and to lend if there is a promise of a real rate of return on their savings, which will allow them to consume more in the future than they would otherwise be able to do. The real rate of return lenders demand thus depends on how much they feel they lose by postponing part of their consumption. Thus, the rate of interest is the reward for waiting – that is, for being willing to delay some of the satisfaction to be obtained from consumption. The extent to which people are willing to postpone consumption depends upon their time preference.  Interest is the payment or reward that you receive for savings left with an institution.
    The term ‘loanable funds’ simply refers to the sums of money offered for lending and demanded by consumers and investors during a given period. The interest rate in the model is determined by the interaction between potential borrowers and potential savers.  An economy’s loanable funds are the funds borrowed and lent in an economy during a specified period of time – the flow of money from surplus to deficit units in the economy. The principal demand for loanable funds thus come from firms undertaking new and replacement investment, including the building up of stocks, and from consumers wishing to spend beyond their disposable income. In addition, some borrowing takes place to allow the building up of liquid reserves. On the surface, it seems rather odd for a firm or a household to borrow in order to add to liquid reserves since the rate of interest received on reserves is bound to be less than that paid on loans. It is, however, a common phenomenon. For example, many households with mortgages maintain liquid reserves – liquidity has a value in itself and people are prepared to pay the spread between borrowing and lending rates of interest in order to retain a degree of liquidity. It follows that the supply of loanable funds includes any rundown in existing liquid reserves together with current savings (the difference between disposable income and planned current consumption). Allowance also has to be made for the net creation of new money by banks since the fractional reserve banking system greatly increases the ability of banks to lend.
    For the economy as a whole, we can net out some of the items above to leave us with:
     
    Real interest rates might differ among countries. In a thrifty society in which must thought was given to the future, the loss of satisfaction from postponing consumption would not seem very great and the real rate of interest would not need to be very high to persuade people to save and to lend. On the other hand, in a society composed of people who only thought of the present, the real rate of interest would need to be high to persuade people to lend. Of course, a society is composed of groups of people with different attitudes towards the present and the future (different rates of time preference). Indeed, the attitudes of individuals are likely to change over lifetimes. It follows that the general attitude towards consumption and savings will be influenced among other things, by the age balance of the population. Further, time preference is very likely to differ between rich and poor. In poor countries with great present needs, high real rates of interest are needed to persuade people to postpone present consumption.

     Poor countries are also short of capital relative to labour. This means that the marginal product of capital is likely to be much higher in poor countries than in rich ones and the demand for loanable funds is likely to be much higher at each rate of interest. The real rate of interest is likely to be much higher in the former. We have here one of the vicious circles of economic underdevelopment. Low income produces low savings, capital is scare and interest rates are high. These high rates of interest discourage investment and the rate of economic growth remains low.
    Clearly, if international capital were highly mobile, funds should flow from rich countries to poor countries in search of higher rates of return and this should narrow the gap in real interest rates between the two groups of countries. With perfectly mobile capital, real interest rates would be equal across all countries. The only reason for nominal rates of interest being different from one country to another would be the different rates of inflation in each country.
It follows that anything that restricts the mobility of capital among countries allows differences in real interest rates to persist. In fact, capital is very mobile internationally but only among developed countries. There are many barriers to the movement of capital to developing countries, particularly to the poorest of the developing countries. Although rates of return on capital are high in developing economies, investment in them usually has many risks, including default risk and foreign exchange risk.

PROBLEMS WITH THE LOANABLE FUNDS THEORY AND THE FISHER EFFECT

    In addition to facing exchange rate risk, an investor may well fear default risk much more in a foreign country than in his own economy. This may simply reflect a lack of information about the degree of risk in foreign countries. On the other hand, default risk may objectively be much higher in developing countries that are constantly short of foreign currency and have a history of unstable governments. Default risk refers specifically to the failure of the borrower to repay a loan. Risk may also arise from the actions of governments. For instance, governments may prevent firms from taking funds out of the country in foreign exchange.
    The Fisher effect assumes that the expectations formed by market agents of the rate of future inflation are invariably correct. If we drop this assumption, we have a problem with the measurement of the real rate of interest since any definition based on expectations must be supported by a model of the way in which expectations or formed. In this case, the real rate of interest might change for two separate reasons – because borrowing and lending conditions have changed or because we change our forecast of the rate of inflation, whether or not that turns out to be justified. Thus, the real rate of interest is always measured as the current nominal rate of interest minus the current rate of inflation. Nonetheless, the monetary authorities must base their interest rate decisions on the rate of inflation expected some considerable time into the future. This is since nay change they are able to bring about in interest rates will only have its full effect after a significant period. In other words, nominal interest rates might change because the authorities have made incorrect forecasts of the rate of inflation.
    Fourthly, the theory assumes that changes in the rate of inflation or expected rate of inflation have no impact to the real rate of interest – the real side of the economy is held to be totally separate from its monetary aspects. This is usually expressed as the belief that money is neutral, having no effect on real variables in the economy such as employment, saving and investment. Unfortunately for theory, there is no doubt that inflationary expectations do influence the willingness of people to save and of potential investors to borrow.
    The direction of the impact of inflation on savings is not certain. The existence or the threat of inflation might persuade people to hold their wealth in the form of real rather than financial assets since real assets maintain their real value during inflations. People thinking in this way would reduce their savings during periods of inflation.
    Changes in the rate of inflation also affect decisions of potential investors. In deciding whether to borrow in order to invest, potential investors assess the probable rates of return on investment projects and compare these with the cost of borrowing. This is much more difficult to do if there is inflation, particularly if the rate of inflation is volatile. The possibility that the inflation rate might change considerably during the period of a loan introduces an extra element of uncertainty into the investment decision.