Classical Theory of Interest Determinants
The classical theory of interest, a cornerstone of classical economics, explains the determination of the interest rate based on the interaction of savings and investment.
According to this theory, the rate of interest is not determined by the quantity of money (as suggested by the quantity theory of money) or by psychological factors alone. Instead, it is determined purely by the interplay of the supply of savings and the demand for investment.
Savings and Investment Function
The classical postulate states that:
- Savings are primarily a function of the rate of interest. A higher interest rate incentivizes individuals and businesses to save more, as they are rewarded more for deferring consumption.
- Investment is also primarily a function of the rate of interest. A lower interest rate makes borrowing cheaper, encouraging businesses to undertake more investment projects. Conversely, a higher interest rate discourages investment.
The equilibrium interest rate is established at the point where the quantity of savings equals the quantity of investment demanded. Therefore, both savings and investment are fundamentally determined by the rate of interest.
Important Questions from Macroeconomics
- A less elastic IS curve means that :
- In Keynesian framework, at full employment, which of the following is/are true ?
(a) Supply curve in the short period is inelastic.
(b) The supply is influenced by the increase in the quantity of money.
Select the answer from the code given below : - When LM curve is vertical, which one of the following is correct ? An increase in money supply will lead to :
- Crowding out will emerge in the economy, if :
- Which among the following were neglected by Keynes in his theory of employment ?
