Another school of thought developed what is called loanable funds theory of interest. Among the principle economists who contributed to the development of loanable funds theory mention may be made of Wicksell and Viner etc. according to this theory, real forces, such as thriftiness, waiting, time preference and productivity of capital alone do not go to determine the rate of interest, monetary forces such as hoarding and dishoarding of money, money credited by banks, monetary loans for consumption purposes also play a part in the determination of the rate of interest. Thus the exponents of the loanable funds theory is a monetary theory of interest, although it is only partly monetary since it also recognizes the importance of real forces such as thriftness and productivity of capital in the determination of the rate of interest.
According to this theory, rate of interest is determined by demand for and supply of loanable funds. The supply of loanable funds consists of savings out of disposable income, dishoarding money aerated by the banks and disinvestment. The demand for loanable funds is composed of the demand for investment, demand for consumption and demand for hoarding money.
Supply of loanable funds
Savings: savings by individuals and households constitute the most important source fo the supply of loanable funds. In the loanable funds theory savings are considered in either of the two ways. Firstly, in the sense of ex-ante savings, that is, savings planned by individuals and households in the beginning of a period in the hope of expected incomes and anticipate expenditures on consumption, and secondly, in the sense of savings, that is, the difference between the income of the preceding period and consumption of the present period. In both these senses of savings it is assumed that the amount of savings varies with rate of interest.
Dishoarding: dishoarding of the past accumulated savings constitutes another source of supply of loanable funds. Individuals may possess idle cash balances hoarded from the incomes of the previous periods which they may dishoard in a period. When people dishoard, the idle cash balances become active cash balances in the present period and thus add to the supply of loanable funds. People hoard money because of their preferences for liquidity. When the rate of interest rises or when the prices of securities decline, they may like to take advantage of these market movements and thus dishoard money for lending it to others or for purchasing securities. At a higher rate of interest, the individuals possessing idle cash balances will be induced to dishoard money. at very low rates of interest, their parting with liquidity will not be rewarded sufficiently and, therefore, they will hold on to money. it is evident that dishoarding is interest-elastic and, therefore, the curve of dishoarding slopes upwards to the right.
Disinvestment: disinvestment is another source of the supply of loanable funds. Disinvestment means disentangling fo the present fixed and working capital. Usually a good amount of depreciation reserves are kept so as to replace the fixed capital when it is completely worn out. As a result, they may bring out the depreciation reserves in the market revenue is earned and replacement is going to be generally contemplate a greater into the market for loanable funds. At higher prices and rates of interest, the entrepreneurs will generally contemplate a rate of interest which means it will find a greater amount of disinvestment. The firm may decide to let it this capital run down and to put the depreciation funds in the loan market. It is therefore; clear that disinvestment curve will also slope upward to the right, as is indicated by the curve shown disinvestment.