Q.Explain the loanable funds theory of interest.
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Start your 14-day free trial to unlock the full solution →The loanable funds theory, developed by neoclassical economists such as Knut Wicksell and Bertil Ohlin, widens the classical (real) theory of interest by incorporating monetary factors alongside the real forces of saving and investment.
On the supply side, loanable funds come from three sources: (a) savings by households and businesses, exactly as in the classical theory; (b) dishoarding — people releasing previously idle money balances back into active circulation, for instance by spending down cash holdings; and (c) new bank credit — the creation of additional loanable funds by the banking system through lending.
On the demand side, loanable funds are demanded for: (a) investment by firms in capital goods, as in the classical theory; (b) government borrowing to finance public expenditure; and (c) hoarding — the desire of individuals or firms to hold additional idle cash balances rather than spend or lend them.
The equilibrium rate of interest is determined at the point where the total demand for loanable funds equals the total supply:
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