The loanable funds theory

An explanation of interest rates which overcomes many of the limitations of earlier theories is the loanable funds approach. This view argues that the risk-free interest rate is determined by the interplay of two forces- the demand for and the supply of loanable funds. The demand for loanable funds consists of credit demands from businesses, consumers, and units of government. The supply of loanable funds stems from three sources-savings, hoarding demand for money, and money creation by the banking system. We consider each of these demand and supply factors in turn.