Answer to Question #146055 in Macroeconomics for Qaisar Ghafoor

Question

Explain how the intrest rate in detirmined in the classical theory

Answer 1

In classical theory, the interest rate is majorly determined by the intersection of the demand curve and the supply curve of saving. This theory is also known as the real theory of interest. It assumes that the market economy is self -regulatory and automatically adjusts to natural real GDP. This interaction is as shown in figure 1 above.

 

In this case, I represent the demand curve, S the supply curve, and E the equilibrium point when OQ is the capital demanded and supplied at R which is the rate of interest. When the rate of interest rises from R to R1, demand for investment decreases, and supply for saving rises. In this case, the supply of savings is more than the demand and hence the interest rate shifts below the equilibrium level, OR. On the other hand, if the interest rate falls from R to R2, the demand for investment will be higher than the supply of savings, therefore making the interest rate rise to R.

When people save more income than the capital demanded, then the rate of interest falls below R because capital demand is constant as illustrated by the shift on the S curve to S1. At a lower interest rate, there will be a low saving rate and higher demand for investment funds which will raise the interest rate to equilibrium, R.