interest rate determination: loanable funds theory and Keynesian theory

Money and Banking – Interest Rate Determination

Loanable Funds Theory (LFT)

Think of the economy as a big bank where households save money (deposit) and firms borrow money (loan). The interest rate is the price of borrowing.

  • Supply of loanable funds = total savings in the economy.

  • Demand for loanable funds = investment demanded by firms.

The equilibrium interest rate, i, is where supply equals demand:

\$S(i) = I(i)\$

When the economy is booming, investment rises → demand curve shifts right → higher interest rate. When savings increase (e.g., people save more), supply curve shifts right → lower interest rate.

Analogy: Imagine a parking lot (the market) with cars (money). If more cars want to park (borrow), the parking fee (interest rate) goes up. If there are more empty spots (savings), the fee goes down.

Keynesian Theory of Interest Rates

Keynes argued that the interest rate is set by the liquidity preference of the public, not by the supply of savings.

Keynesian view:

  1. Liquidity Preference: People prefer to hold money for transactions, precautionary, and speculative motives.

  2. Money Supply (controlled by the Bank of England) influences the price of money (interest rate).

The demand for money is represented by:

\$L(i, Y) = kY - hi\$

where Y is income, k and h are constants. The equilibrium is where money demand equals money supply:

\$M = L(i, Y)\$

In a recession, income Y falls → money demand falls → lower interest rate unless the Bank of England raises the money supply.

Analogy: Think of a vending machine (the market) that sells drinks (money). If people want more drinks (money), the price (interest rate) goes up. If the machine is filled with more drinks (higher money supply), the price goes down.

Comparing LFT and Keynesian Views

AspectLoanable Funds TheoryKeynesian Theory
Main DeterminantSupply of savings vs. demand for investmentLiquidity preference vs. money supply
Role of the Bank of EnglandLimited – mainly influences savings through policy ratesCentral – sets money supply to control interest rates
Policy ImplicationTarget savings rates to influence investmentUse monetary policy (open market operations) to hit target rates

Exam Tips for A-Level Economics

  • Define key terms clearly: interest rate, loanable funds, liquidity preference.

  • Use diagrams: draw supply & demand curves for loanable funds; show money market equilibrium for Keynesian.

  • Explain the effect of a policy change (e.g., increase in money supply) on the interest rate and the economy.

  • Compare the two theories: highlight differences in assumptions, determinants, and policy tools.

  • Use real‑world examples: Bank of England’s quantitative easing (Keynesian) vs. household savings rates (LFT).

  • Remember the “price” of money metaphor to simplify explanations.

  • Practice past exam questions: identify which theory is being asked and structure your answer accordingly.