To Raise, or not to Raise, that is the Question: Loanable Funds Theory of Interest Revisited

Abstract

As Keynes outlines in the General Theory, according to the classical theory of loanable funds, the equilibrium interest rate occurs at the intersection of the saving and investment curves. While the former is derived from the intertemporal choice of consumption, the latter represents the marginal product of capital. Some classical authors, such as Taussig, discuss negative interests in this framework. Since the market interest rate rarely became negative until recently, if the equilibrium interest rate had been negative, the government would have had to fill the saving-investment gap by running a public deficit. Negative interest rates would surely cure this problem. Cassel, however, mentions another possibility, that the saving curve has a downward rather than upward slope. It is problematic because there is a possibility that the saving and investment curves do not intersect at any point. If they do not intersect, lowering interest rates may increase rather than decrease public deficit. Thus, it is essential to identify the shapes of the two curves before taking any policy action, either to raise or to lower the interest rate.