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9.5 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

Figure 9.5 The loanable funds market

S, I







S = I

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.

The Austrian school 491

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