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Some Observations about the Loanable Funds Theory

Listed author(s):
  • Bertocco Giancarlo


    (Department of Economics, University of Insubria, Italy)

The loanable funds theory (hereinafter: LFT) has met a paradoxical fate. Although the fundamental elements of this theory have been accepted by the mainstream monetary theory, few contemporary economists quote it explicitly.1 An important exception can be found in the text of Woodford (2003) who, starting with the very title, makes an explicit link with Wicksell’s work. Woodford (2003, p.25) points out that Wicksell’s theory constitutes the theoretical foundation of the strategy adopted in recent years by the central banks of western countries, i.e. pursuing the objective of price stability through a monetary policy rule based on interest rate manoeuvre.2 Wicksell defines this rule by introducing the distinction between the rate of interest on money and the natural rate of interest, a distinction which has been accepted by the mainstream monetary theory that has supplanted Keynesian theory. Friedman (1968), for example, uses the distinction between natural rate of interest and market rate of interest to explain what monetary policy can and cannot do. Central banks use the wicksellian distinction to affirm that monetary policy can only influence the short term interest rates while in the long run the interest rates are determined by real factors.3 An explicit reference to the LFT can, moreover, be found in the works of the New Keynesians, who set out to re-elaborate the keynesian monetary theory by focusing on the credit market rather than the money market (see for example: Stiglitz and Greenwald 2003). The objective of this paper is to highlight the limits of the LFT based on the arguments used by Keynes to respond to the criticism levelled by Ohlin and Robertson at the keynesian interest rate theory. I believe that these arguments make it possible to elaborate a keynesian theory of credit that is capable of highlighting aspects of the non-neutrality of money that do not emerge from the General Theory, which is focused on the liquidity preference theory. The work is divided into five parts. In the first part the most important aspects of the LFT are described, while in the second one Keynes’s criticism of the LFT is set out. The third part critically analyses Tsiang’s view that supports the validity of Robertson’s position over that of Keynes; the last two sections contain a description of the characteristics of a monetary economy elaborated on the basis of Keynes’s critique of the LFT.

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Paper provided by Department of Economics, University of Insubria in its series Economics and Quantitative Methods with number qf0706.

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Length: 30 pages
Date of creation: Jun 2007
Handle: RePEc:ins:quaeco:qf0706
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