2.3.2.7 Classical theory of interest rate determination

The classical theory of interest rate determination is an economic theory that dates back to the works of classical economists like Adam Smith, David Ricardo, and John Stuart Mill. It provides insights into how interest rates are determined in a market economy with a focus on the interaction of savings and investment. According to the classical theory, interest rates are influenced by the supply of and demand for loanable funds in the economy. Let’s explore the key principles of the classical theory of interest rate determination:

1. Loanable Funds Market: The classical theory envisions a loanable funds market where borrowers (demanders of funds) seek funds for investment projects, and savers (suppliers of funds) provide those funds through savings.
2. Savings-Investment Equality: The core principle of the classical theory is the concept of savings-investment equality. It suggests that total savings in the economy must equal total investment. In other words, the total supply of loanable funds (savings) must be equal to the total demand for loanable funds (investment).
3. Interest Rate as a Price: The interest rate in the classical theory is seen as a price that equates the supply of and demand for loanable funds. It represents the cost of borrowing or the return on savings.
4. Impact of Changes in Savings and Investment: Changes in the supply of and demand for loanable funds lead to changes in the interest rate. For example, an increase in savings or a decrease in investment demand would lower the interest rate, while a decrease in savings or an increase in investment demand would raise the interest rate.
5. Factors Affecting Savings and Investment: The classical theory identifies several factors that influence the supply of and demand for loanable funds, thus affecting interest rates. These factors include changes in income, time preferences of individuals, expectations about the future, and the availability of investment opportunities.
6. Real Interest Rate: The classical theory emphasizes the importance of considering the real interest rate, which accounts for inflation or changes in the purchasing power of money. In a classical framework, the real interest rate is the nominal interest rate adjusted for inflation.