How Is Interest Rate Determined in the Classical Model?

by JoshSimon - Updated September 26, 2017

In the classical model of economics, the interest rate is determined by the amount of savings and investment in an economy. The interest rate adjusts so that the quantity of funds saved is equal to the quantity of money invested.

Supply of Savings

In the classical model, the supply of funds is determined by the amount of money that entities in the economy save. In general, the supply of funds increases along with the interest rate since saving is encouraged if interest rates rise.

Demand for Investment

The demand for funds is determined by the amount of investment occurring in the economy. Economic investment refers to the goods and services purchased for later production. In general, rising interest rates increase the cost of borrowing and thus reduce the amount of investment in an economy.

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Interest Rate Determines Equilibrium

If we assume a closed economy (that is, no goods are imported or exported), the amount of money saved must be equal to the amount of money invested. Like price from the supply and demand model for goods, the interest rate will occur where the savings and investments curves intersect.

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