7.3 Loanable funds in an uncertain economy

savings fall sharply. However, in periods of relatively low ination, the overall effect

is unclear. Because of the importance of expectations, the level of savings (both in

nominal and real terms) might be inuenced not just by the rate of ination but also

by the rate at which the rate of ination is changing (the volatility of ination).

Changes in the rate of ination also affect the decisions of potential investors.

In deciding whether to borrow in order to invest, potential investors assess the

probable rates of return on investment projects and compare these with the cost of

borrowing. This is much more difcult to do if there is ination, particularly if

the rate of ination is volatile. The possibility that the ination rate might change

considerably during the period of a loan introduces an extra element of uncertainty

into the investment decision.

The loanable funds model can be modied to take such complaints into account.

The problem is that these changes are ad hocand run the risk of destroying the central

idea at the heart of loanable funds – that the market economy is stable and has a

strong in-built tendency to return to equilibrium. The real rate of interest is a key

variable in the explanation of how this might happen. It therefore makes sense to look

at a different theory of interest rates – one that is constructed on entirely different

assumptions as to how the economy works. This is known as the liquidity preference

theory of interest rates. Before explaining the liquidity preference theory, let us look

at how the loanable funds approach functions under these different assumptions.

7.3Loanable funds in an uncertain economy

We saw that the loanable funds theory was based on the idea of people allocating

their available resources over their lifetimes. Indeed, to the extent that people save

in order to pass on wealth to their children, the analysis can be extended to future

generations. Thus, the analysis relates to the very long run. In making their decisions,

people are assumed to have full information about future rates of return and ina-

tion and about the effects of their current savings and consumption decisions on

their future levels of income. This can be true only if expectations about the future

are always correct – there is no possibility here, for instance, of people who wish to

work being unemployed.

The difculty is that in an ever-changing world, we never reach the long-run

positions at the heart of loanable funds analysis. The world changes and people begin

to adapt to these changes. Before they have fully adapted, more changes occur and

so the process continues. We can, of course, look back and see what has happened

in an economy over long periods; but each economic agent makes decisions in

a series of short runs. In these circumstances, people may have little idea of future

interest rates or ination rates (and hence future real rates of interest). They may be

quite unsure of their ability to obtain work in the future or of what they will be paid

for their work. If this is true, the notion that the crucial economic decision made by

market agents concerns the allocation of consumption across their lifetimes begins

to seem far-fetched. They may plan to save a particular proportion of their current

incomes, but the absolute level of their savings may change because of unexpected

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Chapter 7 • Interest rates

changes in their incomes. Not only incomes change unexpectedly. In recent decades

in developed countries people have acquired many more assets than used to be the

case (houses, pension entitlements, unit trusts) and have, at the same time, become

much more heavily indebted. Changes in house prices, for example, can have dram-

atic effects on estimates of wealth, as people found out in the early 1990s in the UK

when house prices fell so sharply that many people found the current values of their

houses were less than the size of their mortgages. Where both future income and

estimates of personal wealth are uncertain, the impact of time preference on savings

is dominated by events.

Indeed, it is possible that the positive relationship between interest rates and

savings in the loanable funds theory is reversed for some people. People unable to

think of maximising welfare through the choice between present and future con-

sumption across their lifetimes might well choose to save in order to reach a xed

level of savings by a particular date in the future, for example to allow them to retire.

Any increase in the interest rate then allows them to achieve that target by saving

lessin each period. The relationship between savings and interest rates becomes

negative for them.

Again, savings decisions may be taken out of the hands of those who are in debt.

For many people, a major reason for saving is to allow them to repay their mortgages.

Unexpected increases in interest rates cause debt repayments to increase and require

reductions in consumption. It can be argued that the great increase in indebtedness

has changed the nature of the choice between the present and the future. People

are able to consume more in the current period but lose control of their future

consumption levels.

What does all this amount to? If we return to our supply of loanable funds diagram,

we are suggesting that the slope of the curve is uncertain and that the curve might

shift rapidly with unexpected changes in income and asset prices. The interest rate

might still be an important ceteris paribusinuence, but the effect of interest rate

changes on savings is difcult to see among all the other changes taking place.

The demand for loanable funds is equally problematic if rms are uncertain of

their ability to sell what they produce. The expected rate of return on investment

then no longer depends simply on the marginal productivity of capital but will

be inuenced by factors affecting business condence. These might include the

existing rate of prot, forecasts of the future levels of income and unemployment,

expectations regarding future interest and exchange rates, and political factors such

as possible changes of government. A project might appear to be very protable

on the assumption of full employment, but rms might not invest if they suspect

that the economy is heading into recession. In other words, the demand curve for

loanable funds is also subject to shifts that are difcult to forecast.

If both the demand and supply curves are unstable, the loanable funds theory

does not help us very much in the explanation of the level of or changes in rates of

interest – especially if changes in the rate of interest themselves cause one or both

of the curves to shift. The factors underlying these curves – marginal productivity

and time preference – remain long-term inuences on the rate of interest, but we

cannot say much more than that.

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