The longstanding loanable funds-liquidity preference debate remains unresolved. Textbook Keynesians, Leijonhufvud and the fundamentalists have made their quite distinct contributions.
The textbook version of how interest rates (r) vary with changes in income (Y) stems from Hansen. Saving flows affect r only indirectly by first reducing nominal income and thereby the transactions demand for money. Leijonhufvud2 has criticized Hansen’s analysis on the grounds that dynamic liquidity preference theory makes little sense. Leijonhufvud supports the loanable funds theory because it allows for the possibility that increased thrift directly affects r by increasing the flow of saving relative to the flow of investment. If r immediately fell to clear the initial excess supply of loanable funds, full employment would be preserved. The bears, however, are identified by Leijonhufvud as the agents who syphon the increased savings into speculative hoards and thereby prevent r adjusting fully. The multiplier then causes income to fall. Hansen and Leijonhufvud differ over the sequence of events. In Hansen, r can fall after Y falls because of an excess supply of money spilling over into the financial sector. In Leijonhufvud, Y falls because the prior decline in r was insufficiently large. Because the securities market is the quickest to adjust, r falls only once, and there are no subsequent indirect effects to counteract the downturn.