According to this approach, the interest rate is determined by the demand for and supply of loanable funds.
The term loanable funds includes all forms of credit, such as loans, bonds, or savings deposits.
[4] The loanable funds doctrine extends the classical theory, which determined the interest rate solely by saving and investment, in that it adds bank credit.
Hence, the equilibrium (or market) interest rate is not only influenced by the propensities to save and invest but also by the creation or destruction of fiat money and credit.
The banking system – through its ability to give credit – can influence, and to some extent does affect, the interest level."
In formal terms, the loanable funds doctrine determines the market interest rate through the following equilibrium condition: where
Keynesian liquidity preference theory determines interest and income using two separate equilibrium conditions, namely, the equality of saving and investment,
Like the classical approach, the IS-LM model contains an equilibrium condition that equates saving and investment.
The loanable funds doctrine, by contrast, does not equate saving and investment, both understood in an ex ante sense, but integrates bank credit creation into this equilibrium condition.
[5] An extension of bank credit reduces the interest rate in the same way as an increase in saving.
During the 1930s, and again during the 1950s, the relationship between the loanable funds doctrine and the liquidity preference theory was discussed at length.
This ambiguous use disregards the characteristic feature of the loanable funds doctrine, namely, its integration of bank credit into the theory of interest rate determination.