It seems that the loanable funds theory suggests that all that is saved is supplied in the market for loanable funds. This makes sense when we are talking about 'household saving' (i.e. household income minus consumption). This money will be put on a savings account (or used to buy bonds), and if not, counts as hoarding per definition. I have a hard time grasping why it would be true for 'firm saving'. Let me explain what I mean by that: Assume a production volume of 1 million $ in a given period. Assume further that 800.000 are paid out as wages and that 500.000 of those are consumed. Overall saving is 500.000, household saving is 300.000. It's obvious that the households will want to loan out those 300.000 (and in the case that they hoard some of this money, it constitutes hoarding, i.e. negative dishoarding, and gets subtracted from the supply of loanable funds = saving + dishoarding + newly created money). But I don't understand why the firms would supply the remaining 200.000 as loanable funds. Is there some assumption that profits are rules out in principle, i.e. that production has to equal household income? I'd be very grateful for some clarification, thx in advance.
Does saving increase the supply of credit? Critique of loanable funds theory.
In the first step, the concepts of “saving” and “credit” will be clearly distinguished using simple accounting. It will be shown that credit is not limited by anybody’s saving and that no one has to abstain from consumption in order for a credit to be provided. Also, it will be shown that financial saving (an increase in net financial assets) through a reduction in expenditures reduces other economic units’ revenues and thus their ability to spend and save. Using the concept of excess demand and supply, it will be shown that excess saving does not lead to an excess supply of credit − which would lower interest rates − but to an excess supply of goods, services and/or labor which will lower prices and production. How interest rates change is not determined by excess saving: They could increase, stay the same or decrease. Finally, it will be argued that the identification of saving with the provision of credit is likely to stem from the invalid application of neoclassical growth models to a monetary economy.
The present paper shows that the underlying view of the “saving finances investment” doctrine implies that the amount of loans that can be lent in a period is limited by the amount of saving in the same period and that, consequently,an abstention from consumption (and other spending) is necessary for more credit to be available for investors. This view is the basis of loanable funds theory (Robertson, 1936;Ohlin, 1937a,c,b;Tsiang, 1956). It will be argued that this view is deeply flawed. Using simple accounting rules in the vein of Stützel (1978;1979) and Lavoie and Godley(2012), the paper will first clarify the difference between saving and the provision of credit: saving changes an economic unit’s net worth which the provision of credit does not. The provision of a credit only changes either the composition of a unit’s financial assets or the length of its balance sheet, but not its net worth. Second, it will be shown that loanable funds theorists commit a fallacy of composition when they claim that household financial saving increases aggregate investment in tangible assets.
In recent history Paul Krugman defends the use of loanable funds model in online debates with other economists. The statistical measures in the United States have two components called national income and product accounts (NIPA) and flow of funds accounts (FFA). These debates seem to revolve around what role the interest rate(s) play in the dynamic increase or decrease of production, income, and financial instruments. There does not seem to be any deterministic role for interest rates and the financial accounts are not directly linked to the NIPA accounts because there are accounting methods to re-value assets, to depreciate assets, to recognize casualty losses, and introduce other discontinuities in the financial sectors. In short there is no simple deterministic mechanism to link financial saving and investment in a complex credit-driven economy.