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CHAPTER 5 - Interest Rate Determination ... > THEORIES ABOUT INTEREST RATE DETERMI...

THEORIES ABOUT INTEREST RATE DETERMINATION

There are two economic theories of how the level of interest rates in an economy are determined:
• Loanable funds theory
• Liquidity preference theory
We describe both in this section.

Loanable Funds Theory

In an economy, households, business, and governments supply loanable funds (i.e., credit) in the capital market. The higher the level of interest rates, the more such entities are willing to supply loan funds; the lower the level of interest, the less they are willing to supply. These same entities demand loanable funds, demanding more when the level of interest rates is low and less when interest rates are higher. According to the loanable funds theory, formulated by the Swedish economist Knut Wicksell in the 1900s, the level of interest rates is determined by the supply and demand of loanable funds available in an economy’s credit market (i.e., the sector of the capital markets for long-term debt instruments) More specifically, this theory suggests that investment and savings in the economy determine the level of long-term interest rates. Short-term interest rates, however, are determined by an economy’s financial and monetary conditions.

  

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