Loanable Funds vs. Endogenous Money: Two Theories of Interest

📌 “Banks don’t just lend out deposits; they create deposits by lending.” This simple idea overturns a core assumption of traditional economics. Understanding the debate between Loanable Funds and Endogenous Money is key to grasping how modern banking really works.

In macroeconomics, two main theories explain where money for loans comes from and what determines interest rates: the Loanable Funds Theory and the Endogenous Money Theory. They paint completely different pictures of the banking system.

What is the Loanable Funds Theory?

The Loanable Funds Theory is a traditional, neoclassical view. It sees the financial market like any other market: with supply, demand, and a price (the interest rate).

Supply comes from people’s and businesses’ savings. Banks are just intermediaries that collect these savings and lend them out.
Demand comes from borrowers (investors, home buyers, businesses) who want funds.
Price (Interest Rate) adjusts to balance supply and demand. More savings means lower interest rates, encouraging borrowing. Less savings means higher rates, discouraging borrowing.

The core idea is simple: saving must come before lending. Banks cannot lend more than the total savings available in the economy.

Example 1 The Classic Savings Pool

Imagine an economy where total savings are $1,000. According to Loanable Funds, banks can only lend out up to $1,000. If a business wants a $1,200 loan, it cannot get it unless someone else saves an extra $200 first. The interest rate will rise until some borrowers drop out, matching the $1,000 supply.

🔍 Explanation: This view treats banks as passive middlemen. The amount of money available for loans is fixed by prior savings. Investment is “crowded out” if the government borrows a lot, because it takes funds from the same limited pool.

Example 2 Interest Rate as a Balancing Tool

If many people start saving more, the supply of loanable funds increases. On a supply-and-demand graph, the supply curve shifts right. The new equilibrium has a lower interest rate. This lower rate then encourages businesses to take out more loans for new factories or equipment.

🔍 Explanation: Here, the interest rate is the key mechanism. It ensures that the amount people want to save equals the amount others want to borrow. Policy focus is on encouraging savings to fund investment.

What is the Endogenous Money Theory?

Endogenous Money Theory, associated with Post-Keynesian economics, argues that banks create money “out of thin air” when they make a loan. The word “endogenous” means “created from within” the banking system.

Money Creation: When a bank approves a loan, it simultaneously creates a new deposit in the borrower’s account. This is new money that didn’t exist before.
Savings Follow Lending: Savings are a result of investment and lending, not a prerequisite. The act of spending newly created money generates income, which can then be saved.
Interest Rate Determination: The central bank sets a short-term policy rate (like the Fed Funds Rate). Commercial banks then set their lending rates as a markup over this rate, based on risk and profit targets. The interest rate is largely an administrative decision, not a market price balancing savings and borrowing.

The core idea is: Loans create deposits. Banks are not limited by deposits when they lend.

Example 1 Creating a Mortgage

You walk into a bank for a $300,000 mortgage. The bank checks your credit and approves it. Instantly, it credits your account with $300,000. This is a new deposit—new money. No one had to deposit $300,000 first for the bank to do this. The bank created the money by typing numbers into a computer.

🔍 Explanation: This process adds to the total money supply. The bank’s constraint is not a lack of deposits, but your creditworthiness and its own capital requirements (rules about how much equity it must hold). The money is destroyed when you pay back the loan.

Example 2 Business Expansion

A company wants to build a new warehouse. It gets a $2 million loan from its bank. The bank creates a $2 million deposit for the company. The company pays a construction firm. The construction firm now has $2 million in its bank account (new savings). These savings appeared because the loan was made.

🔍 Explanation: This illustrates the causal reversal: lending creates the deposits that appear as “savings.” The decision to lend is driven by credit demand and bank profit motives, not by the pre-existence of a pool of savings.

Side-by-Side Comparison

Loanable Funds vs. Endogenous Money: Key Differences
Aspect	Loanable Funds Theory	Endogenous Money Theory
Core Process	Saving → Lending	Lending → Deposits (Money Creation)
Role of Banks	Passive intermediaries (match savers & borrowers)	Active creators of money
Money Supply	Exogenous (controlled by central bank, saved first)	Endogenous (created by commercial banks via loans)
Interest Rates	Market price balancing savings supply & loan demand	Administered price (central bank rate + bank markup)
Causality	Savings determine investment	Investment (financed by loans) determines savings
Main Constraint	Availability of prior savings	Borrower creditworthiness & bank capital rules

⚠️ Common Pitfalls and Clarifications

Myth: “Banks lend out reserves.” In Endogenous Money, banks lend first and worry about reserves later. They can always borrow reserves from other banks or the central bank to meet requirements. Reserves follow lending, not the other way around.
Myth: “More savings always lead to more growth.” Loanable Funds assumes this. Endogenous Money argues that if savings are too high and demand for loans is low, it can lead to a recession. Growth is driven by spending and credit creation, not hoarding savings.
Clarification: Endogenous Money doesn’t mean banks can lend infinitely. They face real constraints: regulatory capital ratios, risk management, and finding creditworthy borrowers willing to pay the interest.

Why This Debate Matters

The theory you believe in shapes economic policy.

Under Loanable Funds, to boost investment, you must boost savings (e.g., through tax incentives). Austerity (cutting government spending) can be seen as good because it frees up savings for the private sector.
Under Endogenous Money, investment is limited by demand and credit conditions, not savings. Policy should focus on ensuring strong demand for loans (e.g., through government spending) and regulating bank lending to prevent bubbles. Austerity can be harmful as it kills demand and reduces the creation of new money/income.

Modern central banking operations (like Quantitative Easing) are easier to understand through the Endogenous Money lens, where the central bank manages the price of money (interest rates) rather than directly controlling its quantity.