Keynesian Rebel without a Cause: the Loanable Funds Theory

J.M. Keynes once commented, or is said as such, that he was the only non-Keynesian in the room. Probably he was right.

             First, he in the 1936 book suggests the liquidity preference function, M= L(i), to the effect that the interest rate is the cause and “money demand” the effect. Strangely however, his Disciples rebut that the interest rate is to be determined endogenously of their model even as they before anything else buy into “liquidity preference.” The unintended consequence: One of the two causal directions of contradiction must be wrong.

             Second, the Master discredits in so many words the classical loanable funds “theory” of interest rate. The following year and on, J.R. Hicks and Alvin Hansen, among other macroeconomists, resurrected the so-called “theory” to use it as another pillar of the “fairly well working” IS-LM model. As for loanable funds, “From Eternity to Here”!

             Is the rebel with or without a cause? Absolutely no in both counts!  

             We take all different kinds of interest rates, or “expected rates of return” in finance jargon, into account before making investment in an asset. We hold money in the meantime. In that sense, “the interest rate,” whatever may it mean, plays a role, however trivial may it be in defining "demand for money." Incidentally, most people outside of Cambridge carry an incomparably larger sum of money for transactional and precautionary motives than for speculative; the former with no relation to the interest rate while the latter with a tenuous one if at all. At any rate, the Master is more correct than the Disciples.  

             Now, we turn to the loanable funds theory of interest rate. In a word, the so-claimed “theory” is total nonsense. First, the Gross National Saving (denoted as S) must be identical to the Gross Domestic Investment (I) as per the GAAP: the source on the credit must be equal to the use in the debit. In macroeconomic textbooks, to figure out in a slightly twisted way:

             S≡ Y- (C+ G), by definition, and

             AS= Y= AD= C+ I+ G as an accounting identity so as to

             S≡ 1, always and everywhere, period.

To paraphrase, we may call AD (for Aggregate Demand) the Gross Domestic Expenditures as opposed to AS (for Aggregate Supply)≡ Y (the Gross Domestic Products). Whatever we do, the national-income accounts will equalize the two sides as long as they are CPAs.

             To be more professional, funds for the “loan market,” as it were, would be a drop is the ocean of funds for all the assets, physical and financial, in the economy. A drop influences the mobility of ocean surface? It’s up to you.

             An interesting question on the sidewalk in Cambridge: When the economic prospect improves, do interest rates go up or down? Answer: Down in financial markets all across the nation while up in the “loanable funds market” of the city.