Question

Discuss the classical theory of the determination of the rate of interest.

Short answer

Answer: The classical theory of interest rate determination is based on the loanable funds market, where the supply of funds (savings) and the demand for funds (investments) interact to set the interest rate. The key components of this theory are the role of savings and investment in determining interest rates. The main assumptions of the classical theory are full employment of resources, flexible wages and prices, savings determined by the interest rate, and investment determined by the interest rate.

Step-by-step solution

1. Introduction to classical theory

The classical theory of interest rate determination primarily focuses on the loanable funds market, which is where savers (those who have a surplus of income over expenditures) supply funds to borrowers (those who have a deficit in their income and require additional funds). In this market, the interest rate is determined by the forces of supply and demand for loanable funds.

2. Savings and interest rates

In the classical theory, savings play a crucial role in determining the interest rate. The theory posits that as the interest rate increases, people are more willing to save because they can earn more money on their savings. Conversely, as the interest rate decreases, people may be less inclined to save and might be more willing to spend or invest their money.

3. Investment and interest rates

Investment is also an important factor in the determination of the interest rate. Firms and businesses invest in projects that they expect will yield a return greater than the cost of borrowing (i.e., the interest rate). Therefore, as the interest rate increases, businesses may find fewer projects that are worth investing in, leading to a decrease in demand for loanable funds. On the other hand, as the interest rate decreases, more businesses might find projects whose expected returns are greater than the cost of borrowing, increasing the demand for loanable funds.

4. Equilibrium in the loanable funds market

The equilibrium interest rate is reached when the supply of loanable funds (savings) equals the demand for loanable funds (investments). At this equilibrium rate, all funds supplied by savers are borrowed by investors, ensuring that there is neither a surplus nor a shortage of funds in this market.

5. Key assumptions of the classical theory

An important step to understand the classical theory of interest rate determination is to be aware of its main assumptions: - Full employment of resources: The classical theory assumes that resources (such as labor and capital) are always fully employed, so any change in the interest rate will not have an impact on output or employment. - Flexible wages and prices: Wages and prices are assumed to be flexible and adjust quickly to changes in demand or supply, eliminating any persistent imbalances in the market. - Savings are determined by the interest rate: According to the classical theory, the interest rate is the main driver of people's saving decisions, and thus savings are directly responsive to changes in the interest rate. - Investment is determined by the interest rate: Similar to savings, the interest rate determines firms' investment choices. By understanding these key assumptions and recognizing the role of savings and investment in the loanable funds market, it becomes easier to grasp the classical theory of the determination of the rate of interest.