Classical Theory of Interest Rate : The Loanable Fund Theory 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 (bond with no fixed maturity period). Interest rate depends on the factors that determine the levels of supply of bonds and the demand for bonds.

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 Copyright © Dorling Kindersley India Pvt. Ltd.

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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.

Where, G :Govt. expenditure and T :Tax revenue. 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). Total supply is from the savings. Where, G :Govt. expenditure and T :Tax revenue. The equilibrium interest rate is determined at SS = DD Copyright © Dorling Kindersley India Pvt. Ltd.

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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.

Role of Interest rate in the Classical System. 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 (distance I ) 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. There is a induced change is the Investment. As interest rate , 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Role of Interest rate in the Classical System. So, the equilibrium is set at r1 with saving = Investment At the new equilibrium, increase in the consumption (A) and increase in the induced 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. Copyright © Dorling Kindersley India Pvt. Ltd.

How does the increase in spending is financed? Taxation 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.

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. Copyright © Dorling Kindersley India Pvt. Ltd.

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). Copyright © Dorling Kindersley India Pvt. Ltd.

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. Copyright © Dorling Kindersley India Pvt. Ltd.

Example of Crowding out Year Gross Private Domestic Investment Savings Gross Government Interest Rate 2007 520.9 537.8 17.7 10.27 2008 518.8 541.7 24.8 10.37 2009 516.1 576.5 -55.9 10.86 2010 514.2 600.4 -85.7 11.79 2011 510.0 605.6 -95.4 11.93 2012 509.3 610.5 -100.9 12.33 Copyright © Dorling Kindersley India Pvt. Ltd.

(a)What happened to the demand for loanable funds from 2007-2012? 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. Copyright © Dorling Kindersley India Pvt. Ltd.

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. Copyright © Dorling Kindersley India Pvt. Ltd.

Example 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Example 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.

Policy Implications of Tax Policy: Demand Side Effects 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Policy Implications of Tax Policy: Supply Side Effects 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.

Policy Implications of Tax Policy 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. Copyright © Dorling Kindersley India Pvt. Ltd.

Copyright © Dorling Kindersley India Pvt. Ltd.