INTEREST RATES IN THE CLASSICAL MODEL

INTEREST RATES IN THE CLASSICAL MODEL

Nominal vs.Real Interest Rates

 Real interest rate =Nominal rate -      Inflation rate

r                      =                     r           -           p

LOANABLE FUNDS

Demand for funds: those who are deficit spending units (specially those in business  who want to invest) borrow.In the classical model, the desire to spend more depends negatively on the real rate of interest.  As real rate of interest rises, cost of borrowing will be higher and therefore, less is borrowed. 

Supply of Loanable funds come from those who are surplus spending units. 

Supply  of funds are positively related to the real rate of interest rates.  As real rates rise, more current consumption are forgone for the higher future consumption. 

EQUILIBRIUM INTEREST RATE

Interest Rates and Government Deficits

Government is a big borrower in the market.  When they run a deficit, they usually borrow.  This means higher demand for Loanable funds and higher interest rates.

Higher real interest rates would have two effects:

private saving increases while private consumption decreases.  (remember that in the classical model income is fixed.  People can change the composition of their S/C.

 Since cost of borrowing has increased, businesses will borrow and invest less, i2

Equilibrium Interest rate

Equilibrium Interest rate and Government Surplus

In contrast to the case where there is a deficit, a government surplus adds to the supply of loanable funds. 

Equilibrium Interest rate

Monetary and Interest Rates

In the classical model, Saving and Investment are real variables and not affected by the monetary policy.  Higher money supply determines inflation rate and therefore higher nominal interest rates -- not real interest rates.

Purchasing Power Parity

Exchange rate is value of one currency in terms of another.  In a perfect world, if there are discrepancies among prices around the world, arbitrage will equalize them.  So value of  one currency in terms of another does not change. 

  However, if there is persistent inflation in one country, one currency loses its purchasing power and therefore loses its value relative to another currency and it must depreciate.

PPP(Purchasing Power Parity)

E = P / P*

where:

P  = domestic price level

P* =foreign price level

E  = exchange rate

An increase in the domestic price level, means higher E -- more dollars per foreign currency.

That is, depreciation of the dollar.