Irving Fisher Demolishes the Loanable-Funds Theory of Interest

In some recent posts (here, here and here) I have discussed the inappropriate application of partial-equilibrium analysis (aka supply-demand analysis) when the conditions under which the ceteris paribus assumption underlying partial-equilibrium analysis are not satisfied. The two examples of inappropriate application of partial equilibrium analysis I have mentioned were: 1) drawing a supply curve of labor and demand curve for labor to explain aggregate unemployment in the economy, and 2) drawing a supply curve of loanable funds and a demand curve for loanable funds to explain the rate of interest. In neither case can one assume that a change in the wage of labor or in the rate of interest can occur without at the same time causing the demand curve and the supply curve to shift from their original position to a new one. Because of the feedback effects from a change in the wage or a change in the rate of interest inevitably cause the demand and supply curves to shift, the standard supply-and-demand analysis breaks down in the face of such feedback effects.

I pointed out that while Keynes correctly observed that demand-and-supply analysis of the labor market was inappropriate, it is puzzling that it did not occur to him that demand-and-supply analysis could not be used to explain the rate of interest.

Keynes explained the rate of interest as a measure of the liquidity premium commanded by holders of money for parting with liquidity when lending money to a borrower. That view is sometimes contrasted with Fisher’s explanation of the rate interest as a measure of the productivity of capital in shifting output from the present to the future and the time preference of individuals for consuming in the present rather waiting to consume in the future. Sometimes the Fisherian theory of the rate of interest is juxtaposed with the Keynesian theory by contrasting the liquidity preference theory with a loanable-funds theory. But that contrast between liquidity preference and loanable funds misrepresents Fisher’s view, because a loanable funds theory is also an inappropriate misapplication of partial-equilibrium analysis when general-equilibrium anlaysis is required.

I recently came upon a passage from Fisher’s classic 1907 treatise, The Rate of Interest: Its Nature, Determination and Relation to Economic Phenomena, which explicitly rejects supply-demand analysis of the market for loanable funds as a useful way of explaining the rate of interest. Here is how Fisher made that fundamental point.

If a modern business man is asked what determines the rate of interest, he may usually be expected to answer, “the supply and demand of loanable money.” But “supply and demand” is a phrase which has been too often into service to cover up difficult problems. Even economists have been prone to employ it to describe economic causation which they could not unravel. It was once wittily remarked of the early writers on economic problems, “Catch a parrot and teach him to say ‘supply and demand,’ and you have an excellent economist.” Prices, wages, rent, interest, and profits were thought to be fully “explained” by this glib phrase. It is true that every ratio of exchange is due to the resultant of causes operating on the buyer and seller, and we may classify these as “demand” and supply.” But this fact does not relieve us of the necessity of examining specifically the two sets of causes, including utility in its effect on demand, and cost in its effect on supply. Consequently, when we say that the rate of interest is due to the supply and demand of “capital” or of “money” or of “loans,” we are very far from having an adequate explanation. It is true that when merchants seek to discount bills at a bank in large numbers and for large amounts, the rate of interest will tend to be low. But we must inquire for what purposes and from what causes merchants thus apply to a bank for the discount of loans and others supply the bank with the funds to be loaned. The real problem is: What causes make the demand for loans and what causes make the supply? This question is not answered by the summary “supply and demand” theory. The explanation is not simply that those who have little capital demand them. In fact, the contrary is often the case. The depositors in savings banks are the lenders, and they are usually poor, whereas those to whom the savings bank in turn lends the funds are relatively rich. (pp. 6-7)

Advertisements

3 Responses to “Irving Fisher Demolishes the Loanable-Funds Theory of Interest”


  1. 1 burk August 9, 2019 at 8:24 am

    But this hardly even touches the real point, which is that banks do not even need funds in order to lend. Their lending is covered by an elastic / infinite supply of central bank reserves, not by deposited funds. They are limited by their capital via regulation, not by their stock of deposits- not these days. See MMT.

  2. 2 Kurt Schuler August 10, 2019 at 9:00 am

    Are you or Fisher saying anything other than at a sufficiently high level of aggregation that there’s not just movement along the curves, but that the curves themselves may shift, and that the shifts may be frequent?


  1. 1 Links (8/08/19) - Nagaland Jackpot Teer Result News Trackback on August 8, 2019 at 12:48 pm

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.




About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,352 other followers

Follow Uneasy Money on WordPress.com
Advertisements

%d bloggers like this: