Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

4. 8.3 Critical Evaluation: 
There is no denying that the exponents of the loanable fund 
theory had a better under standing of the events in the capital 
market. It was realised that the flow of money on to the market was 
not the same thing as voluntary savings. They also realised that the 
flow of securities on to the market was not the same thing as 
investment. It was realised that the flow! of money on to the market 
could be regulated by monetary authorities. It was also understood 
that the flow of securties on the market depended not only on the 
need to borrow for investment by the issue of new securities but 
also on the attitude of the investors towards) the holding of existing 
securities. 
The loanable fund theory made another correction in the 
classical theory The exponents 
I 
of the theory had understood the 
importance of changes in asset preferences in determining | prices 
in the capital market. It was clearly seen that quite independently of 
savings and| investment, a selling or buying pressure could be built 
up as a result of investors desiring to 
I 
have more or less idle cash 
balances. Thus, they incorporated the concept off hoarding
—
demand for money
—into their analysis. 
The loanable funds theory brings out the fact that the rate of 
interest established on the basis of the demand and supply of 
loanable funds is different from that which is arrived at by the 
intersection of the saving and investment curves. In this theory, 
unlike the classical theory, there is no equilibrium between savings 
and investment. 
Even though the exponents of the loanable fund theory tried 
to synthesize the classical and the Keynesian theories of interest by 
taking into consideration the saving and investment demand (in real 
terms) of the classical theory and liquidity preference (monetary) of 
Keynes, it is still open to some basic criticism. 
1. As pointed out by Newlyn, "the theory is really a mixture of flows 
and stocks-voluntary savings and investment expenditure are 
straight forward flow concepts, just as they are in the classical 

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theory, but hoarding and new money are not
—They are in fact 
changes in stocks These magnitudes cannot be defined without 
reference to some time period. It is therefore necessary to specify a 
time period applicable to the analysis. 
2. Hansen has pointed out that the theory is indeterminate, that is, it 
cannot determine interest. According to this theory, supply of 
loanable funds is one of the two factors determining rate of interest. 
But supply of loanable funds is a function of (depends on) income ; 
income depends upon investment, and investment, in turn, is 
governed by the rate of interest. It means that we must first know 
the rate of interest before we can determine investment, income, 
and finally the supply of loanable funds. The theory which needs 
before-hand knowledge of the rate of interest cannot itself explain 
the determination of the rate of interest. 
3. According to Ackley, the loanable fund theory, when viewed as a 
statement of static equilibrium condition, presents nothing new. In 
static equilibrium position, both bank money (BM) and hoarding (H) 
must be zero. Thus, we are left with savings and investment only 
and we go back to the classical theory. It is better to regard it as a 
disequilibrium theory concerned with dynamic analysis. 
4. The theory is also criticised for combining monetary factors with 
the real factors influencing the rate of interest. The two sets of 
factors are totally different as regards their origin and impact. They 
should, therefore, be separately accounted for by taking income 
changes as the reconciling factor. Only then, we can get a 
determinate theory of interest. 
5. Keynes regards the concept of hoarding as used in the loanable 
fund theory as dubious. His argument is that so long as amount of 
money remains the same, hoarding simply can not increase or 
decrease. Money in circulation in the economy has to be in 
somebody's cash balances at any time. The hoarding of money by 
one person is cancelled by the dishoarding of another. This 
criticism of the theory is misplaced because while keynes takes 
stock of money at a point of time, the loanable fund theory takes 
flow of loanable funds over a period of time. Halm rightly observes 
that "The total quantity of money may well be the same in the 
beginning and end of the period, but the velocity of circulation of 
money may nevertheless have changed ; and it is this change in 
velocity of circulation of money which is partly caused by hoarding. 
An increase in idle balances at the expense of active balances is 
hoarding and results in a reduction in the velocity of circulation of 
money. The time duration of the idleness of money might change, 
changing at the same time the supply of loan able funds." 

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Despite these limitations, the loan able fund theory marks an 
improvement on the classical theory in the following respects. 
1. The loan able fund theory assigns an active role to money in the 
determination of the rate of interest, where as the classical theory 
treats money as a passive factor
—a mere veil. 
2. The loan able fund theory is more realistic because it is stated in 
both real as well as monetary terms. The classical theory, in 
contrast, is stated only in real terms. 
3. The loan able fund theory takes into account the influence of 
bank credit and hoarding. Bank credit influences the supply of 
money while hoarding is a factor influencing demand for loan able 
funds. These two factors were just ignored by classical economists.