Interest and profit: loanable funds theory and innovation theory

1. Interest: meaning

Interest is the price paid for the use of capital (money) for a period. The gross interest a lender receives includes, besides net (pure) interest, payment for risk of default, payment for the trouble of managing the loan, and compensation for inconvenience. Theories of interest explain net interest.

The classical theory (Marshall, Pigou) held that interest is the reward for saving (waiting) and is fixed by the real demand for capital (investment) and the real supply of capital (saving). Its weakness was that it ignored money, hoarding and bank credit.

2. Loanable funds theory

Also called the neo-classical theory, it was developed by Knut Wicksell and by D.H. Robertson, Bertil Ohlin, Gunnar Myrdal, Erik Lindahl and Jacob Viner. Interest is the price paid for loanable funds, and the rate of interest is determined by the demand for and supply of loanable funds. It brings both real and monetary factors into the explanation.

Supply of loanable funds comes from four sources:

1. Savings (S) of households and firms; more is saved at higher rates of interest.
2. Dishoarding (DH): people bring out idle cash balances to lend when the rate is high.
3. Bank credit (BM): commercial banks create credit and lend it.
4. Disinvestment (DI): firms do not replace worn-out capital and lend the depreciation funds instead.

Demand for loanable funds comes from three sources:

1. Investment (I): firms borrow to buy capital goods; less is borrowed at higher rates, since fewer projects then yield more than the rate.
2. Hoarding (H): people wish to hold idle cash; the higher the rate, the costlier it is to hoard.
3. Consumption loans (DC): households borrow for consumption, especially durable goods and in emergencies.

Equilibrium. The rate of interest settles where:

S + DH + BM + DI = I + H + DC

Worked schedule (Rs. crore).

At 8 per cent lenders offer more than borrowers want, and competition among lenders lowers the rate; at 4 per cent borrowers want more than is offered, and the rate rises. The equilibrium rate is 6 per cent, with Rs. 300 crore lent.

Diagram (described). Loanable funds on the horizontal axis and the rate of interest on the vertical. The supply curve (S + DH + BM + DI) slopes upward; the demand curve (I + H + DC) slopes downward. They cross at the equilibrium rate. An increase in bank credit shifts the supply curve to the right and lowers the rate; a rise in investment demand shifts the demand curve to the right and raises it.

3. Merits and criticism

Merits. It is more realistic than the classical theory because it includes monetary factors (hoarding, dishoarding, bank credit) along with real ones (saving, investment); it recognises that saving and investment need not be equal, the gap being filled by credit and hoarding; and it explains how the banking system and monetary policy influence the rate of interest.

Criticism.

• Indeterminate (Keynes, Hansen). Saving depends on income, and income depends on investment, which depends on the rate of interest. Unless income is known, the supply curve of savings is not known, and unless the rate is known, income is not known. The theory reasons in a circle.
• Mixes stocks and flows: savings and investment are flows per period, whereas hoards and bank money are stocks.
• Assumes full employment, so it does not allow for changes in income from changes in investment.
• Saving is not very interest-elastic: people save mainly out of income and habit.
• Bank credit is controlled by the central bank and does not respond freely to the rate.

Keynes offered the liquidity preference theory in the General Theory (1936) instead. Hicks and Hansen later combined the loanable funds and liquidity preference approaches in the IS–LM framework, in which income and interest are determined together.

4. Profit: meaning

Profit is the reward of the entrepreneur, a residual: what is left after paying rent, wages and interest. Gross profit includes implicit rent, wages and interest on the entrepreneur’s own factors, depreciation and the reward for management. Net (pure) profit is the reward for enterprise alone. Normal profit is the minimum needed to keep the entrepreneur in the industry and is part of cost; anything above it is supernormal profit. Unlike other factor incomes, profit is uncertain and can be negative.

Several theories explain it: the dynamic theory of J.B. Clark (profit arises from change), the risk theory of F.B. Hawley (profit is the reward for bearing risk), the uncertainty theory of F.H. Knight in Risk, Uncertainty and Profit (1921) (profit is the reward for bearing non-insurable uncertainty), and the innovation theory.

5. Innovation theory of profit (Schumpeter)

Joseph A. Schumpeter set out the theory in The Theory of Economic Development (German 1911; English translation 1934). He begins with a circular flow: a stationary economy in which the same goods are produced year after year by the same methods, revenue just equals cost (including wages of management and interest), and there is no profit.

Profit arises only when an entrepreneur introduces an innovation that breaks the circular flow by lowering costs or creating new demand. Schumpeter listed five kinds of innovation:

1. introduction of a new good or a new quality of a good;
2. introduction of a new method of production;
3. opening of a new market;
4. conquest of a new source of raw materials or semi-finished goods;
5. a new organisation of an industry, such as creating or breaking a monopoly.

Innovation and invention. An invention is a new discovery; an innovation is its commercial application. The scientist invents; the entrepreneur innovates. Profit is the reward of innovation, not invention.

Profit is temporary. Once an innovation succeeds, other firms imitate it, competition increases supply, prices fall, and profit disappears. The economy returns to a new circular flow, until another innovation creates fresh profit. Schumpeter called this process “creative destruction” (in Capitalism, Socialism and Democracy, 1942), and saw the waves of innovation and imitation as the cause of trade cycles and economic growth.

Criticism.

• Risk and uncertainty ignored: Knight argued that bearing uncertainty, not innovation alone, is the source of profit. Innovation is itself uncertain.
• Profit has other sources: monopoly power, windfall price changes and good management also yield profit.
• The entrepreneur is not only an innovator; most businessmen run established firms without innovating, yet earn profit.
• Innovation is now done by large firms’ research departments, not by individual heroic entrepreneurs.
• The circular flow with zero profit is an abstraction.

Even so, the theory explains well why profits are highest in new industries and fall as an industry matures.

How this is examined

“Loanable fund theory of interest” was a 10-mark note in June 2025 (100-mark, Q.9) and “Analyse loanable fund theory of interest” a 10-mark essay in June 2025 (80-mark). “Innovation theory of profit” was a 6-mark note in June 2025 (80-mark). For loanable funds, the equation, the schedule and Keynes’ indeterminacy criticism carry the marks.