Classical theory of Interest:
1. The equilibrium interest rate, according to classical theory, is determined by the intersection of demand and supply curves, Demand for money refers to investment.
2. Supply of money is refers to savings. S = I.
Equilibrium:
1. The rate of interest is determined by the equilibrium between the total demand for and the total supply of loanable funds.
2. Supply of and Demand for Loanable funds:
3. Supply of loanable funds = Savings + Bank Credit + Dishoarding + Disinvestment = S + BC + DH + DI
4. Demand for loanable funds = Investment + consumption + Hoarding = I + C + H
- In Diagram X axis represents the demand for and supply of loanable funds and Y axis represents the rate of interest.
- The LS curve represents the total supply curve of loanable funds.
- The summation of the Saving Curve [S], Bank credit curve [BC], Dishoarding curve [DH] and Disinvestment curve [DI],
- The LD curve represents the total demand for loanable funds.
- This is obtained by the summation of the demand for investment curve I, demand curve for consumption demand or dissaving curve and curve for demand for hoarding curve H.
- The LD and LS curves, intersect each other at the point “E” the equilibrium point.
- At this point, OR rate of interest and OM is the amount of loanable funds.
