Loanable Funds Theory

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JOURNAL OF ECONOMICS AND FINANCE EDUCATION • Volume 6 • Number 1 • Summer 2007

48

Reconsidering the Introduction to Interest Rate Theory
S. Kirk Elwood1
ABSTRACT The various theories of interest rate determination presented in economics textbooks each spotlight a particular fundamental force behind the equilibrium rate. Unfortunately, each theory’s successful emphasis of one determinant of the interest rate comes at the cost of distorting some other aspect of its determination. This paper argues that the basic market analysis of debt securities (e.g., bonds and commercial paper) left out of most macroeconomic as well as money and banking textbooks provides a straightforward and practical perspective on interest rate determination that can help students navigate the established interest rate theories.

Introduction
Loanable funds theory, liquidity preference theory, the IS/LM model’s determination of the interest rate, and the more recent general equilibrium-based models of interest rate determination, together share the role of interest rate theory in the economics curriculum. Each theory’s advantage stems from its focus on some deeper force behind the determination of interest rates. Unfortunately, each theory’s successful emphasis of one determinant simultaneously causes the theory to awkwardly represent – if not misrepresent – other facets of interest rates, which can confuse those attempting to understand them. Faced with both the evident strengths and weaknesses of the different theories, the new (as well as the old) student of economics is left to figure out which of the theories is most applicable when evaluating a given situation involving interest rates. In addition to these prominent theories, there is the more basic approach that derives interest rates from the price of debt securities (e.g., bonds and commercial paper) which, in turn, are determined by debt securities markets. Although nobody disputes that all actual interest rates are derived from the pricing of some debt security, and that the prices of the major debt securities are determined by thick and visible primary and secondary markets, this approach to interest rate determination is not presented in either introductory or intermediate macroeconomics textbooks.2 There are undergraduate money and banking textbooks (e.g., Croushore, 2007, Mishkin, 2003) that would appear to offer a version of the debt securities market to explain the determination of interest rates. However, as will be discussed below, their modifications of the market model to capture the same flows that distinguish loanable funds theory causes it to be theoretically identical to the loanable funds approach. Whereas quoting debt security prices is effectively equivalent to speaking of the interest rates on specific loans, treating debt security prices and interest rates as market clearing prices from theoretically equivalent markets does not follow. The difference arises because debt securities prices adjust to equate quantities demanded and supplied of those assets, while interest rates are traditionally interpreted as eliciting the quantities of funds to be borrowed and lent, with the equilibrium interest rate equating those amounts in the creation of new debt securities.

1

S. Kirk Elwood, Associate Professor of Economics, James Madison University, Harrisonburg, VA 22807, elwoodsk@jmu.edu.

2 Most introductory macroeconomics texts (e.g., Frank and Bernanke 2007, and O’Sullivan and Sheffrin 2003) discuss the inverse relationship between interest rates and bond prices, but they do not present bond markets or how bond prices are determined within those markets. There are some that do not even discuss bond or debt securities prices (e.g., Mankiw 2003). Stiglitz and Walsh (2006) are an exception in depicting the Fed Funds rate as determined by the Fed Funds market for reserves and, in their final chapter (entitled “A Student’s Guide to Investing” ), they employ a varient...
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