Saturday, December 21, 2013

Classical Theory of the rate of Interest

It is also known as the Supply-Demand Theory of the rate of Interest, or the Savings-Investment Theory.

Higher the rate of interest, higher will be the supply of savings. But the investors will invest less because interest is the cost of acquisition of an asset.

Investment is the demand for loanable funds, and savings is the supply of loanable funds.
According to the classical theory, which is the real theory of the rate of interest, the equilibrium rate of interest is determined by the interaction of the demand-for-investment curve and supply-of-savings curve. Although for the economy as a whole, savings is equal to investment, savers and investors are two different groups of people. Savings is mainly undertaken by the household sector, and investment is undertaken by private business firms. From the savers' point of view the rate of interest is the return on an asset or simply the return on money. From the investors' point of view, the rate of interest is a cost factor. It is the cost of borrowing money in order to acquire an asset. These two reasons adequately explain why savings is directly related to the rate of interest, and investment is inversely related to the rate of interest. Higher the rate of interest, higher will be the savings and lower the investment, and vice versa.

In the diagram the downward sloping demand-for-investment curve intersects the upward sloping supply-of-savings curve at point E. At the point E savings is equal to investment, and the resultant rate of interest is r, which is called the equilibrium rate of interest.
Criticism: The classical theory of the rate of interest focuses its attention on the real variables, namely savings and investment, and ignores the monetary factors, namely demand for money and supply of money and certain other things. It is to remedy this deficiency, J.M. Keynes developed the most important theory regarding the determination of the rate of interest, namely The Liquidity Preference Theory of the rate of Interest. In the Liquidity Preference Theory all motives for holding money, namely transactions motive (a classical concept), precautionary motive (again a classical concept) and speculatory motive (basically a Keynesian concept) have been considered. The whole Liquidity Preference Theory is based on speculatory motive for holding money.

No comments:

Post a Comment

Want to say something? Say it!

Update(s):Post(s) under preparation: -
View Chandra Bhanu's Art at


Related Posts Plugin for WordPress, Blogger...


indifference curve investment demand-pull inflation economy fiscal policy monetary policy cost-push inflation demand demand for money destabilized economy economics stagflation supply of money Opportunity Cost Quantity Theory of Money Theory of Consumption World economy automatic stabilizer capital choice consumption function current accounts deficit deflationary gap demand for investment depression derivation effects of inflation equilibrium fiscal deficit fresh investment growth imbalance inflation interest money perfect competition savings savings function world Accounting Profit Adam Smith Alfred Marshall Diminishing Marginal Utility Economic Profit Equimarginal Utility General Equilibrium Theory IS Curve J. M. Keynes Keynes' Theory of employment LM Curve Lionel Robbins Normal Profit PPC Production Possibility curve Software system development Utility Analysis accelerator account accounting alternative uses autonomous investment balance of payments book keeping capital goods classical theory of the rate of interest commodity consumer consumer goods consumption credit debit definition deflation discretionary double entry economic functions economic wants educated education ends energy ermployment full employment functions of money growth rate habit imitation imperfect competition income income analysis income determination income effect induced investment inflationary gap investment function knowledge labour less than full employment liquidity preference theory long run long run equilibrium means monetary analysis monetary measures monopoly multiplier price price effect price maker production possibility frontier profit maximization propensity revealed preference analysis sacrifice say's Law scarce science shifts of IS LM curves short run short run equilibrium shut down conditions slow down society stagnation student subsidies subsidy substitution effect success sunk capital supply supply of savings technology unproductive wealth world economy 2012