Criticism of the Loanable Funds Theory

Criticism of the Loanable Funds Theory:

Loanable Funds Theory though an improvement over the classical theory, is yet not free from defects and shortcomings. The theory has been criticized on the following grounds:

Firstly, as pointed out by the critics, this theory exaggerates the effect of the rate of interest on savings. In fact, the rate of interest does not influence the volume of savings as much as suggested by the theory. Sometimes it happens that people start saving more without any increase in the rate of interest. Such a thing happens in abnormal circumstances. Besides, there are some people whose savings are interest-inelastic. Even if the rate of interest falls to zero, they will not stop saving.

Secondly, the critics point out that, like the classical theory, the loanable funds theory is also based on the assumption that the income of the community remains constant and that the volume of investment has no effect on it. But this is opposed to reality. When the volume of investment increases consequent upon the fall in the rate of interest, the level of income in the community also increases. We cannot accept the implications of the loanable funds theory that the level of investment has no effect on the income level of the community.

Thirdly, as pointed out by the American economist, Prof. Hansen, this theory is indeterminate. The theory does not clearly tell us how the rate of interest is determined. According to this theory, the rate of interest is determined by loanable funds. But the loanable funds themselves depend upon disposable income. And disposable income itself ultimately depends upon the level of investment. The level of investment, as we know, depends upon the rate of interest. Thus, as pointed out by Prof. Hansen, we get into a vicious circle out of which we find it difficult to extricate ourselves.

Fourthly, the critics have objected to the way the monetary factors have been combined with the real factors in the loanable funds theory. The main weakness of the classical theory was that it explained the rate of interest in terms of real factors only. The loanable funds theory tried to get over this weakness by combing the real factors with the monetary factors. But it has not succeeded in this attempt. How can, the critics argue, real factors like savings and investment be combined with monetary factors like bank credit and liquidity preference?

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