Answer to Question #95241 in Macroeconomics for komal

Question

Explain how the interest rate is determined in the classical theory.

Answer 1

Determination of Interest Rate in Classical Theory

In classical theory,the interest rate is majorly determined by the intersection of demand curve and 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 the figure 1 below.

 

In this case,I represents 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 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 supply of savings, therefore making 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 low saving rate and higher demand for investment funds which will raise interest rate to equilibrium,R.

Reference

Meghana S:The Classical Theory of Interest ( With Criticisms).29 sept 2019<https://www.microeconomicsnotes.com/-theories/theory-of-interest/the-classical-theory-of-interest-with-criticisms/1334>.