Learn about the comparison between loanable funds theory and preference theory.
Two main theories of interest that have been an integral part of economics since the 1930s are the loanable funds theory and the liquidity preference theory.
In sum, the loanable funds theory holds that the interest rate is determined by the demand for and supply of loanable funds only, as distinguished from all money. The sources of demand for loanable funds are business that want to invest, households that want to finance necessary consumption purchases and governments that want to finance deficits.
The sources of supply of loanable funds are the central banking system which influences the supply of money (and hence loanable funds) in the economy and households and businesses that make loanable funds available out of their past or present savings.
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On the contrary, the liquidity preference theory of interest (formulated by J. M. Keynes) contends that people would rather hold their assets or wealth in the most liquid form, namely, cash, in order to satisfy three motives: the ‘transactions motive’ to carry out everyday purchasing needs; the ‘precautionary motive’ to meet possible unforeseen circumstances and the ‘speculative motive’ to take advantage of a rise in interest rates.
Accordingly, interest is the price or reward that must be paid to overcome liquidity preference. And as we have seen in the macroeconomic context the equilibrium rate of interest is determined by the demand for and supply of money.
These two approaches should not be regarded as alternative theories of interest. Although they involve many complexities, they tend to supplement and complement each other rather than compete.