Classical Interest Rate

Theory
Classical Interest Rate Theory
Interest rates is determined by supply
of and demand for loanable funds (LF).
What is loanable funds market?
Where do supply of and demand for
loanable funds come from?
Loanable Funds Market
Refers to the market where savers and borrowers exchange funds (QLF) at
the rate of interest (r%).
Savers are households, firms and government sectors who buy bonds,
thus creating supply the LF.
 This is called saving (S) = supply of LF
 So, the supply of LF (savings) is the demand for bonds.
Borrowers are households, firms and government sectors who sell
bonds, thus creating demand for LF.
 Investment and budget deficit (G-T) = demand for LF
 So, the demand for LF (I + G-T) is the supply of bonds.
Equilibrium interest rate is the rate at which Qty of LF demanded = Qty
of LF supplied.
 the point of intersection between supply and demand curves
Supply of LF (Savings)
Qty of savings is positively related to the
rate of interest —the higher the rate of
interest, the more will be saved.
Interest earned on savings is a reward for
delaying consumption in favor of future
consumption
At higher interest rates people will be more
willing to forgo present consumption, so
saving increases
Demand for LF
 Assume that government borrowing is zero
(balanced budget), demand for LF comes from
Investment
◦ Investors borrow to make investment.
◦ The cost of borrowing is the interest charges.
◦ The lower the rate of interest, the more
entrepreneurs will borrow and invest
◦ Therefore, investment depends negatively on
the rate of interest.
Equilibrium Rate of Interest
 Happens when quantity
of total savings = quantity
of total investment
 Represented by the
intersection between the
supply and demand
curves for loanable funds.
 The equilibrium rate of
interest is r
Changes in the Equilibrium Rate of Interest
Happens due to shifts in supply and/or
demand
Any shift in the supply or demand for
loanable funds will cause market forces to
drive the rate of interest back into
equilibrium at a different level
This flexibility in the rate of interest will
ensure that the amount of savings is always
equal to investment and total income will
always equal total spending
Increased saving calls forth increased investment
An autonomous increase in S
shifts the curve to the right
At the old equilibrium, there is

an excess saving over

investment.
This gives pressures on the rate

of interest to fall.
Interest rate will fall until the

new equilibrium is established.

Both saving and investment

increase at the new

equilibrium
Autonomous Increase in Investment
An autonomous increase in I shifts
the curve to the right (I1 to I2)
I increases by the distance A + B
the equilibrium r increases from r1
to r2.
S increase, which is an equal
decrease in C (distance A)
The increase in the r causes a
decline in I (distance B)
The interest rate-induced decline
in C and I just balances the
autonomous increase in I.
Therefore, AD & output do not
change.
Autonomous Decline in Investment
• An autonomous decline in
investment shifts the curve to the left
(I1 to I2)
• Investment falls from I1 to I3
• The equilibrium interest rate falls (r1
to r2)
• Savings falls from S1 to S2, which is an
equal increase in consumption.
• The reduction in the interest rate
causes an increase in investment
from I3 to I2
• The interest rate-induced increase in
consumption and investment just
balances the autonomous decline in
investment.
• Therefore output does not change.
Increase in Government Spending
• Equilibrium is at r0 and S0 = I0 r
• Government budget deficit (G-T)
shifts DLF to I + G - T S
• The equilibrium r increases from r1
A B C
to r2
r1
• The increase in r causes ar declineEin
0
investment from I0 to I1
• Savings increases, which is an equal I + G-T)
decrease in consumption (S0 to S1) I
• The decline I and C just balances the
I1 S0=I0 S1 S,I, G-T
increase in deficit spending.
• Therefore AD and output do not
change.
Conclusion
Monetary and fiscal policy is ineffective in
affecting real variables
Increase in quantity of money increases AD,
but, since AS is vertical, output remains fixed.
A change in G or I has no independent effect
on AD since the interest rate adjusts to
stabilize AD.
Output and employment depend on
population, technology, and capital formation