The Loanable Funds theorists believed in the time preference explanation of how interest arises. According to Loanable Funds theory, interest is the price paid for the use of Loanable Funds. It asserts that the rate of interest is determined by the equilibrium between demand and supply of Loanable Funds in the credit market. The supply of Loanable Funds is derived from four basic sources, namely, savings, dishoarding, bank credit and disinvestment.

Savings by individuals or households constitute the most important source of Loanable Funds. In the Loanable Funds theory, savings are looked at in either or these two ways, firstly, as ex-ante savings, i.e., savings planned by individuals at the beginning of a period in the hope of expected incomes and anticipated expenditures on consumption, or secondly, savings of the difference between the income of the preceding period and the consumption of the present period.

Like individuals, businesses also save. A high rate of interest is likely to encourage business savings as a substitute for borrowings from the loan market. But these business savings are often demanded for investment purposes by the firms themselves and, therefore, they do not enter the market for Loanable Funds.

Dishoarding is another source of Loanable Funds. Individuals may dishoard money from the

hoarded stock of the previous period. Thus, cash balances, lying idle in a previous period, become active balances in the present period and are available as Loanable Funds. At higher rates of interest, more will be dishoarded. At very low rates of interest, there is a greater tendency to hold on to money.

The banking system provides a source of Loanable Funds. Banks, by creating credit money, can advance loans to the businessman. Banks can also reduce the amount of money by contracting their lending. The new money created by the banks in a period adds greatly to the supply of loan funds. The supply curve of funds provided by banks is to some degree interest-elastic, i.e., it varies with various rates of interest.

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