Loanable funds theory is inconsistent with data

10 October, 2016 at 18:14 | Posted in Economics | 1 Comment

Loanable funds doctrine dates back to the early nineteenth century and was forcefully restated by the Swedish economist Knut Wicksell around the turn of the twentieth (with implications for inflation not pursued here). It was repudiated in 1936 by John Maynard Keynes in his General Theory. Before that he was merely a leading post-Wicksellian rather than the greatest economist of his and later times.

loanable_funds_curve-13fec80c6110b93d6d9Like Keynes, Wicksell recognized that saving and investment have different determining factors, and also thought that households provide most saving. Unlike Keynes, he argued that “the” interest rate as opposed to the level of output can adjust to assure macro balance. If potential investment falls short of saving, then the rate will, maybe with some help from inflation and the central bank, decrease. Households will save less and firms seek to invest more. The supply of loanable funds will go down and demand up, until the two flows equalize with the interest rate at its “natural” level …

Wicksell and Keynes planted red herrings for future economists by concentrating on household saving and business investment. They did not observe that trade and government injections and leakages play bigger roles in determining effective demand. Keynes made a major contribution by switching the emphasis from interest rate adjustments to changes in income as the key macroeconomic adjustment mechanism. In so doing, he argued that the interest rate and asset prices must be set in markets for stocks, not flows, of financial claims …

Today’s New “Keynesians” have tremendous intellectual firepower. The puzzle is why they revert to Wicksell on loanable funds and the natural rate while ignoring Keynes’s innovations. Maybe, as he said in the preface to the General Theory, “The difficulty lies, not in the new ideas, but in escaping from the old ones …”

Lance Taylor

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  1. “Wicksell and Keynes planted red herrings for future economists by concentrating on household saving and business investment. They did not observe that trade and government injections and leakages play bigger roles in determining effective demand.”

    At the time Wicksell and Keynes wrote, perhaps household saving and business investment were the bigger numbers?


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