Determination of Interest

Rates

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 Theories of Interest Rate
determination
 Classical Theory of Interest

 Loanable fund theory of Interest

 Liquidity Preference theory

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 Classical Theory of Interest
 Supply of Capital
Savings =f(roi)------+ve function

 Demand for capital

Investment= f(roi)------ (-ve) function

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Classical Theory of Interest

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 Criticism:

 Interest reward for saving:

 Indeterminate theory: roisavingsroi
 Money is neutral and serve as medium of
exchange.
 Savings # f(roi) but on income
 Do not consider capital meant for consumption
 Do not consider Bank credit/newly created
money.

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 Loanable Funds Theory
 Wicksell, Ohlin, Mydral, Robertson
 Commonly used to explain interest rate
movements
 Suggests that market interest rates are
determined by the supply and demand for
loanable funds
 Some sectors of the economy supply loanable
funds, other demand loanable funds

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 Loanable Funds Theory

 Demand for Loanable Funds

 Demand loanable funds to Consumption:
like finance housing, automobiles,
household items
 Investment:
 Hoarding:
 There is an inverse relationship between
the interest rate and the quantity of loanable
funds demanded
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Interest
Rate

Quantity of Loanable Funds

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 Loanable Funds Theory

 Supply of Loanable Funds

 Refers to funds provided to markets
 Savings: HH, Business, Govt.
 Bank Credit:
 Dishoarding:
 Disinvestment:

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Interest S
Rate

Quantity of Loanable Funds

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 Loanable Funds Theory

 Supply of Loanable Funds

Supply= S+B+DH+DI
 Demand for Loanable Funds
Demand= I+C+H
Equilibrium:
I+C+H= S+B+DH+DI

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 Graphic Presentation

Supply of Loanable Funds

Interest
Rates

Demand for Loanable Funds

Quantity of Loanable Funds

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 Loanable Funds Theory

 Graphic Presentation
 When a disequilibrium situation exists,
market forces should cause an adjustment
in interest rates until equilibrium is achieved
• Example: interest rate above equilibrium
• Surplus of loanable funds
• Rate falls
• Quantity supplied reduced, quantity
demanded increases until equilibrium

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 Criticism:
 Hoarding:
 Indeterminate: roi Loanable funds
Investmentroi
 Ignores the impact of investment of income

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