Loanable Funds Theory
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
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
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