Classical Theory of Interest Rate

Classical Theory of Interest Rate
In classical theory, the component of consumption,

investment and government expenditures play their explicit
role in determining interest rate.
The equilibrium interest rate, the rate at which the amount
of funds the individual desired to lend = amount others
desired to borrow.
Borrowing Selling a Bond
Lending Buying a bond
Here bond means Perpetuity.
Interest rate depends on the factors that determine the
levels of supply of bonds and the demand for bonds.
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Supply of the Bonds
Suppliers of the Bonds Firms and the Governments

The level of Govt. deficits the Govt. wants to finance
through Bonds
The difference amount between Govt. spending and tax
revenue, to be financed through the issue of bonds.
The level of business investment was a function of the
expected profitability of the business and cost of
investments
For a given expected profitability, the investment
expenditure demand varies inversely with cost of
investments.
Supply of Bonds is same as Demand for Funds
Demand for bonds

Demanders of the bonds household, firms,
governments.
Demand for bond is the same as supply of funds.
Saving is positively related to the interest rates
Act of saving forgoing the present consumption to
have command over the goods and services in the
future periods.
There is a trade-off between current consumption and
future consumption.
Interest rate is one of the variables which determine the
trade-off between consumption and savings.
Classical Theory of Interest Rate

The classical theory of interest rate is determined by the
loanable fund theory.
In the above diagram, the saving(S) is plotted as an
upward sloping function of the interest rate.
Saving provides the demand for bonds or supply of
loanable funds.
Investment (I) is negatively sloped schedule plotted
against the interest rate.
The total demand for loanable funds or the supply of
bonds comes from I + (G-T)
Where, G Govt. expenditure and T Tax revenue.
The equilibrium interest rate is determined at SS = DD

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Role of Interest rate in the Classical System.
Let us consider the situation of economic depression due

to the fear of war.
Hence, the expected profitability of investment would
reduce.
Hence the investment would reduce at each level of
interest rates.
The demand curve for loanable funds would shift to the
left.
Assuming the supply curve for the funds remain same,
the equilibrium interest rate would fall.
Suppose, the govt. budget is balanced, G = T

I is the only source of fund demand.
A fall in the expected profitability is shown by the shift
in the investment demand from Io I1
At the initial interest rate and after the shift in the
investment, the supply of LF > demand for LF and there
is pressure on the interest rate to fall.
Hence, savings decline by the distance A.
As Saving declines, Consumption increases by the same
amount as Y= C + S.
Moreover, as interest declined, investment revives by
the distance B in the diagram.

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So, the equilibrium is set at r1 with saving = Investment

At the new equilibrium, increase in the consumption (A)
and increase in the investment (B) is the same as the
original decline in the autonomous investment.
Because of the adjustments of the interest rate, the sum
of the private sector demand (C + I) is unaffected by
the autonomous decline in the investment demand.
Hence, interest rate plays as stabilizing role in the
classical system.
Policy Implications
Consider a case of the effect of an increase in Govt.

spending in the system.
How does the increase in spending is financed?
Taxation
Creating New Money
Selling bonds to the public
Borrowing from the international agencies.
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Policy Implications
Assuming fixed Money supply and fixed tax collection, if

the Govt. proposes selling bonds to the public for
financing the deficits, the demand for loanable funds
shift to I + (G T).
Due to this, the demand curve shows a shift to right and
the equilibrium interest rate changes from initial point to
new point.
With the increase in the interest rate, saving in the
economy increases by the distance A in the graph.
And there is an equal amount decline in the
consumption in the economy.

12
Policy Implications
With an increase in the interest rate, the investment has

declined by the distance of B in the diagram.
So. A + B = G T
The increase in the Govt. spending financed by selling
bonds to the public, increases the interest rate which
crow-out and equal amount of private expenditure (C +
I) in the economy.
Private expenditure is discouraged because the higher
interest rate causes household to go for future
consumption (save more).
Policy Implications
As the interest increases, the investment declines as

fewer projects appear profitable with higher borrowing
costs.
It is this crowding out effect that keeps the aggregate
demand unchanged and hence, price is not affected.
Policy Implications of Tax Policy

If the government Cut the Tax and sold bond to the
public to replace the revenue lost due to tax cut, the
same crowding out process would follow, as in the case
of bond-financing to increase the government spending.
The equilibrium interest rate would rise, investment
would fall.
There is also interest rate induced saving, consumption
would fall towards the pre tax cut level.
Hence, the aggregate demand would not change.
If the revenue lost is replaced by printing notes, this
may leads to increase in the price.
If tax cut is in the form of percentage, it would affect

the labour supply. The change would affect the supply
side of the model and would affect output and
employment.
The affect of this tax policy is shown in the following
diagram.
The change in the marginal income tax rate would affect
the labour supply behaviour.
A cut in the tax rate would increase labour supply at any
value of pretax real wage and would shift the labour
supply curve to the right.
The shift follows because the worker is concerned about

the after tax real wage (1-t) (W/P) where t is the
marginal income tax rate.
With the new supply curve and the unchanged demand
curve, we found the reduction in the marginal tax rate
would induce more employment and hence, more
output.
Finally, this would decrease the price in the economy as
shown in the last panel graph.

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Example of Crowding out

Year
Gross Private
Domestic
Investment
Gross
Private
Savings
Gross
Government
Savings
Interest
Rate
2007
2008
2009
2010
2011
2012
520.9
518.8
516.1
514.2
510.0
509.3
537.8
541.7
576.5
600.4
605.6
610.5
17.7
24.8
-55.9
-85.7
-95.4
-100.9
10.27
10.37
10.86
11.79
11.93
12.33
With the help of data presented in the above

table, answer the following questions;
(a)What happened to the demand for loanable
funds from 2007-2012?
(b)Can the behavior of the demand for and
supply of loanable funds be reconciled with
observed interest rates for the same period?
(c)Does the data appear to show a Crowding out
effect? Explain.
Answer
The demand for loanable funds comes from the supply

of bonds which includes the private domestic investment
and Government deficits. From the data we found that
the economy had negative government savings from
2009. This means they have deficit. Hence, in
calculation of the demand for loanable funds we have to
add I to the deficits since 2009. Hence, demand
increased from 2007 till 2012
Yes. we found from the data that when the interest rate
increases from 10.27 continuously in the economy, the
domestic private investment decreases continuously.
Further, as the interest rate increases, the

domestic saving increases during the period.
Hence, the observed trend support the behavior
of loanable fund theory as explained by the
classical.
Yes, crowding out happens as the interest rate
increases the private domestic investment
declines. So, in this case with an increase in the
government investment, the private investment
is declined continuously.
This is basically due to the fact that when

budgetary deficit increases, the gap between
supply of loanable funds and demand for loanable
funds at the current interest rate creates a
pressure on the interest rate to increase. As the
interest rate increases, the private domestic
investment decreases.
This trend is visible through out (2009 to 2012).
Hence, we conclude that the crowding out effect is
present in the economy during the period of
analysis.
Keynesian System I : Role of Aggregate Demand
The Problem of Unemployment: The Keynesian Economics was

developed against the background of the great depression of 1930s.
The effect of depression on the US economy: unemployment
increases from 3.2% in 1929 to 25.2% in 1933.
Real GNP decreased by 30%
According to JM Keynes, high unemployment in GB and US and
other economies was due to deficiency in aggregate demand.
Aggregate demand was low due to low investment demand.
Keynes says, to remove unemployment, aggregate demand has to
increase, which need fiscal policy and govt. in the form of spending
on public work project.
Keynesian System I : Role of Aggregate Demand
Central notion in keynesian model in achieving an equilibrium level

of output requires, Output = Aggregate demand.
Aggregate demand = E = C + I + G
C = HH consumption
I = Desired business investment
G = govt. sector demand for goods and services.
GDP = GNP (closed economy)
GDP = NDP (depreciation ignored)
Aggregate price level is fixed
Y = national income = C + S + T
Income is either consumed, saved or paid out as taxes.
Y = national product = C + Ir + G
Ir = realised investment
G = govt spending
C = consumption
Income = Expenditure
C+S+T=Y=C+I+G
S+T
=I+G
Product = Expenditure
C + Ir + G = C + I + G
So, Ir = I
So, the condtion for equilibrium in the model is

Y=C+I+G
S+T=I+G
Ir = I

Classical Theory of Interest Rate

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Classical Theory of Interest Rate

In classical theory, the component of consumption,

Copyright Dorling Kindersley India Pvt. Ltd.

Supply of the Bonds

Suppliers of the Bonds Firms and the Governments

Demand for bonds

Copyright Dorling Kindersley India Pvt. Ltd.

Copyright Dorling Kindersley India Pvt. Ltd.