MACRO ECONOMICS

Classical Theory of Interest

Dr. Ketan S. Vira

 Introduction

 Interest
 Rate of Interest
 Impacts economic activities
 Determined by demand and supply of money
 Determined by demand and supply of Capital
 Demand for Capital

 Demanded only for the purpose of Investment

 Inversely related
 Comparison of rate of return with rate of interest
 Downward sloping curve
 Supply of Capital

 Source is Savings
 Income that is withhold from consumption
 Saving is a function of rate of interest
 Full employment
 Income does not influence saving in the short run
 Savings is upward sloping
Interest Rate Determination
Changes in Saving and Investment
 Critical Appraisal

• Saving is a unique function of interest rate

• Keynes disagree to Saving is a unique function of interest rate
• Saving function will shift with changes in income
• Fails to realize the relationship between investment and income
 Base for further refinements
 Accepted for several years
 Loanable Fund Theory

 Extension of the classical theory

 Incorporated both monetary and non-monetary factors
 Assumptions:
 Fully integrated with perfect mobility of funds
 Perfect competition
 All factors other than rate of interest are constant
 Flow terms
 Demand for Loanable Fund

 LD = I + MD
 Both I and MD are decreasing function of the rate of interest
 So, LD is decreasing function of the rate of interest
 Investment is a real factor whereas the incremental demand for money is
monetary factors, both real and monetary factors are included in the
demand for money
 Supply of Loanable Fund

 LS = S+ DH + M
 Both S and DH are increasing function of the rate of interest
 M is given autonomously
 LS is also increasing function of the rate of interest
Interest Rate Determination
 Critical Appraisal

 Loanable funds are demanded for purposes other than investment expenditures and also
that besides savings there exist other sources too
 Real and Monetary factors are included
 Dishoarding and the incremental demand for money influence the rate of interest
 Some savings may not come through loan market
 Not all dishoarding are lent out
 Investments and hoardings may be financed from owned funds
 Funds are not borrowed only for investments
 Equilibrium approach has several criticism
 Rate of interest is also affected by several variables
 Variety of interest rates
Thank You