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.
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.
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