7.2 The loanable funds theory of real interest rates

7.2.2Problems with the loanable funds theory

Unsurprisingly, the loanable funds theory has some problems. Firstly, it is clear that

people go on saving even when real interest rates become negative and remain so

for quite long periods. This can only occur in the model outlined above through the

existence of money illusion. It happens only in the short run (when the system is in

disequilibrium). In equilibrium, suppliers and demanders of loanable funds are per-

fectly informed about the real rate of interest. This means, however, that the model

does not do very well in explaining changes in interest rates over what economists

refer to as the short run, but this can involve quite long periods of actual time.

Secondly, real as well as nominal interest rates are capable of changing rapidly. For

example, in the US from December 2004 to December 2005, the Federal Funds rate

– the rate of interest controlled by the US central bank – was raised from 2 per cent

to 4.25 per cent although the rate of ination increased only from 2.7 to 3 per cent.

Even allowing for the likelihood that expected ination rates might have been higher,

it remains clear that the real interest rate rose signicantly during the year.

We can see that the concentration on the long run in the loanable funds approach

to interest rates seriously understates the role of the monetary authorities in a

modern economy. After all, the Federal Reserve changed interest rates so often in

2005 because it wanted to have an impact on real interest rates, with the aim of

preventing the US economy from expanding too rapidly. Equally, when in February

2003 the Bank of England Monetary Policy Committee took everyone by surprise by

lowering its repo rate from 4 to 3.75 per cent, it was intending to lower real interest

rates because it was worried by the performance of the real economy in the UK.

This change is looked at in more detail in Box 7.1.

Box 7.1

The Monetary Policy Committee’s interest rate decision – February 2003

In February 2003, the Monetary Policy Committee of the Bank of England surprised

nancial markets by cutting its repo rate from 4 per cent to 3.75 per cent. Before this

decision, the rate had been held steady at 4 per cent since November 2001. Why were

the markets surprised by the February decision?

It was widely accepted that the UK economy was going through a period of slow

growth and many forecasts suggested that the rate of growth would decline further.

Manufacturing industry was doing particularly badly and business organisations had

been asking for an interest rate cut for some months. The trade unions, concerned about

increasing unemployment, also sought a cut. However, there was considerable concern

that the economy was dangerously unbalanced. In particular, house prices were con-

tinuing to increase rapidly and mortgage borrowing and household debt had grown to

record levels. Some analysts talked of a house price bubble and argued that the longer

the bubble persisted, the bigger would be the collapse in prices when it eventually came.

An interest rate cut, they thought, would cause house prices and debt to rise even faster

in the short run and thus make a large ‘correction’ more likely.

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Chapter 7 • Interest rates

Such a collapse in house prices would lead to large reductions in consumption as

households sought to come to terms with their debt and the lower value of their houses

and other assets. A sharp reduction in consumption could tip the UK economy into a

full recession. Therefore the nancial markets had convinced themselves that the MPC

would not cut interest rates.

When it happened, the interest rate cut was praised by the Director General of the

Confederation of British Industry (CBI), but the FTSE share index, the value of sterling

and gilt prices all fell sharply, providing ample evidence that the markets had been taken

by surprise (see Box 7.6 for more information on the impact on gilt prices).

We can interpret the difference in view as a clash between the real and nancial

economies. The case for an interest rate cut grew easily out of standard economic theory

– the economy was growing slowly, inationary pressures were weak and slow growth

was also forecast in the US and Europe, making the prospects for export industries

gloomy. There seemed a strong case for cutting the repo rate in order to prompt interest

rates generally in the economy to fall. This would push down real interest rates and so

encourage rms to invest. The argument against the cut was based on the psychology

of markets and consumers and on asset prices and nancial ratios.

The MPC surprised the markets by opting for the cut in real interest rates in line with

economic theory. This led the markets to wonder whether the Bank of England had

information not available to the markets suggesting that the state of the economy was

worse than the markets had thought. This turned out not to be the case. In the minutes of

the MPC meeting, the seven MPC members who voted for the interest rate cut included

in their reasons for doing so worries about weakening demand at home and abroad, dis-

sipating inationary pressures, weak equity markets and ‘geopolitical worries’ (which at

the time meant uncertainty regarding the likelihood of war in Iraq and its consequences).

Thirdly, there is another problem stemming from the assumption that the rate of

ination or the expected rate of ination has no long-run impact on the real rate of

interest. Unfortunately for the theory, there is no doubt that inationary expectations

do inuence the willingness of people to save and of potential investors to borrow.

The direction of the impact of ination on saving is not certain. The existence of, or

the threat of, ination might persuade people to hold their wealth in the form of

real rather than nancial assets since real assets (on average, over the medium term

or long term) maintain their real value during inations. People thinking in this

way would reduce their savings during periods of ination. However, in some past

inationary periods people have responded to the ination by saving more rather

than less. Why might they have done this?

People hold a considerable part of their wealth in the form of nancial assets. With

ination, the real value of these assets falls. It is perfectly logical to respond to this

by consuming less now and adding to holdings of nancial assets in order to offset

in part the impact of ination on past savings. It follows that the impact of ination

on savers is ambiguous. Clearly, much depends on the rate of ination and expecta-

tions about future ination rates. When ination rates are very high, people attempt

to convert all of their past savings into goods as quickly as they can as well as refusing

to buy nancial assets from current income. There is no doubt that in these periods

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