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## Classical Theory and the Role of Interest Rates

Question:

Discuss about the Alternative Theories Rate of Interest.

The statement “the interest rate is an equilibrating price matching the desire to save with the desire to invest” have attracted discussion over the years. Various economist have provided their opinions on the issue of savings, investment and the rate of interest. Classicists expressed their opinion on the statement and came to conclusion that the rate of interest is the main reward which is given to people for acceptinginvestments such as bond and securities instead of liquidity. Different opinions have also been expressed by other economist regarding the same. The content of this paper critically illustrates various issues regarding the statement “The interest rate is an equilibrating price matching the desire to save with the desire to invest” and concludes on the same based on various economic theories.

The above statement is true based on Keynes theory which states that various factors management such as abstinence and time period have no effect on the ability of an individual to part with liquidity as well as payment of interest. According to Keynes theory, interest is not compensation for the abstinence an individual saver has undergone or the time he has taken without the liquidity. However, as mentioned above interest rate is the reward an individual receives as a reward for investing his or her savings for a given period of time (Ahiakpor, 2015).  Rate of interest therefore acts as a measure of the level which makes an individual saver to part with the liquid cash to make claims or accept non-liquid claims instead of cash. Based on this theory, the interest rate is therefore an equilibrating price matching the desire to save with the desire to invest as most people in the current world tend to invest or accept non-liquid claims based on the rate of interest thus the balance.

The state of balance between savings and investment comes as a result of rate of interest. This is well explained by classical theory, which states that economy is at equilibrium only when the savings rate is equal to the rate of investment realized. With such sound economic reasoning t savings is equals to investments at equilibrium and this comes as a result of rate of interest even though this theory is not that clear (Friedman, 2010). The theory by classicalist explain that, when the desire to save decrease, the rate of interest will automatically increase to fuel savings and a curtailed desire to invest.  However, this automatic correction of the disequilibrium between savings and investment only occurs in a full employment situation. Based on the classicists’ ideology the equality between the savings and investments occurs as a result of an automatic flow of equal amount of investment through changes in the rate of interest to give full employment level income.

## Keynesian Theory and the Role of Income

This equality between savings and investments is clearly brought about by rate of interest when the economy is on motions and other variable are constant. When variables are at the normal functioning relationship to each other, the rate of savings is therefore equal the rate of investment and are not always not only equal but at equilibrium. At such point where savings equals the rate of investment, the effect of rate of interest is crucial and can be witnessed (Ahiakpor, 2015). This is because, when investment in such economy moves up to exceed savings, the balance of the two variables is then caused by rate of interest.  Interest rate is an equilibrating price matching the desire to save with the desire to invest where by when  investments exceed savings a condition of imbalance between them is created and the rate of interest rises to correct the imbalance through discouraging investment thereby increasing savings (Westphal,2013).

Moreover, when savings are higher above investments, the rate of interest moves down encouraging Investment management while decreasing savings (Wong, 2016). Based on this classical opinion, changes in the rate of interest results into correction of disequilibrium between savings and investment (Friedman, 2010).  According to the above argument therefore confirms the statement that the ‘interest rate is an equilibrating price matching the desire to save with the desire to invest’.  This statement can as well be illustrated in an economic model known as the IS curve which illustrates that, at every rate of interest, savers in most cases would want to invest more leading to an increased demand higher than the expected investment level, this demand results into shifting outwards of the IS curve leading to an increased income and savings.

The interest rate therefore takes control to balance disequilibrium between investment and savings in since other factors such as money supply and income cannot solve the problem. As indicated above, when other variables remain constant such as money supply, interest rate rises to restore the equilibrium balance between savings and investment. This rise in the rate of interest leads to an offset in investment demand while increases savings as illustrated through the rightward shift of the IS curve above (Hicks, 2007).  The statement is also true when the level of income remains constant, an increase in the demand for liquidity results into shifts in an LM model which also explains the relationship between rates of interest, savings as well as investment where interest rate is necessary for the equilibration of investment and savings as illustrated in the two diagrams below.

## Debates and Setbacks to the Statement

The shift in the above diagram indicates the rise in the interest rate in order to restore the imbalance in the equilibrium between the desire to save and the desire to invest (Hicks, 2007). With the increase in the rate of interest the desire to invest falls leading to increased savings as indicated below.

Contrary to the above opinion as illustrated by various economists, the statement ‘interest rate is an equilibrating price matching the desire to save with the desire to invest’ cannot be justified as a fact. This is because the theory excludes various factors which are crucial and normally results into the balance between the desire to save and the desire to invest apart from the rate of interest (Hicks, 2007).  According to various economist with various opinions, the change in rate of interest cannot be the only factor which results into an equilibrium between the desire to invest and the desire to save.  Changes in the rates of interest alone according to other economists cannot bring the balance between savings and investment as the desire to invest and the desire to save also depend on other marginal factors such as capital as well as other factors.

A part from capital the equilibrium can between investment and saving comes as result of changes in income of an individual saver rather than as a result of changes in the rate of interest. According to the Keynes theory, it evident that equilibrium between the desire to save and desire to invest can be reached considerably lower than full employment known as underemployment equilibrium (Dooley, Frankel & Mathieson, 2007). Keynes further explained that so long as the shapes of both investment schedule and saving schedule as well as liquidity schedule are focused further then equilibrium is created between savings desires as well as investment desires (Skidelsky, 2010). The opinion of Keynes just as the classical theory in relation to the statement is quite clear, it is true as he claims that investment will not smoothly flow in order to match savings with the changes in rate of interest. Howsoever, other various factors such as flexibility in wages, prices as well as cost must be considered to ensure the equality.

The statement according to Keynes suffers various setbacks; when there is a depressions, investment demand schedule does not respond to changes in the interest rate thus cannot result into state of equilibrium between the desire to invest and the desire to save. Even though investment demand schedule may be inelastic small changes occur in the rate of interest, however, such changes cannot result into a meaningful change on investment (Skidelsky, 2010).  Moreover, savings with regards to the assumptions by Keynes are similarly inelastic to small changes in the rate of interest thus even though there are considerable changes in the rate of interest there will be no significant change in the savers mind to make more savings.

## Conclusion

Further, majority of people have the desire to have cash as many fear to invest based on profit and loss speculation, so even with high rates of interest majority will tend to hold on the liquid cash resulting into a few investing thus no meaningful change in investment. A situation   known as popularly called liquidity function (Wray, 2010). From these three assumption one can therefore deduce an idea that, the rate of investment by various private entrepreneurs is derived with the speculation on profits. This further show that interest rate is not the only factor which may result into a match between the desire to invest and the desire to save as privately driven economy profit motive is the only drive to investment.

After stating various setbacks to the statement that ‘interest rate is an equilibrating price matching the desire to save with the desire to invest’, the theory developed by Keynes agrees that there is equality and match in the savers desire to invest and the desire but fails to support that this equality is caused by rate of interest (Garegnani, 2008). According to his theory he brings into consideration that the equality which exists between savings and investment comes as a result of the level of income as such equality exists in all levels of employment not only in a full employment (Wray, 2012).  He then suggests that the state of equilibrium between the desire to save and the desire to invest comes as a result of changes in the savers income (Chenery, Lewis, De Melo & Robinson, 2015). From such argument it can be agreeable that the rate interest is not only the mechanism which can be used to bring equality between investment and saving but another mechanism which income level can be used to explain the same.

The two theories bot the classical and Keynes theory agree on the state of equilibrium between the desire to invest and the desire to save but disagree on the mechanism which result into the equilibrium. The two arguments takes various situations where one views the equality in a full employment situation while the other views the equity at every level of employment (Wray, 2012).  . In relation to accounting equity theory, one may pick on the Keynes theory to be the most appropriate as the two theories support each other, however, given explanations by Keynes does not match the saving and investment in terms of price. Based on the models illustrated above it is clear that the statement ‘interest rate is an equilibrating price matching the desire to save with the desire to invest’ is true and it occurs at a full employment as detailed. The change in the rate of interest results into changes in desire of an individual to invest of save (Wray, 2010).

Conclusion

Based on the argument within the content of the essay and after deeply weighing both theories, the statement ‘interest rate is an equilibrating price matching the desire to save with the desire to invest’ is true and justifiable. The rate of interest serves as a very crucial factor in equilibrating the desire to invest and the desire to save.  This is because when all other factors are kept constant and are moving normally within an economy, the only equilibrating mechanism which can be employed to create balance between the desire to invest and the desire to save is the rate interest. In a situation where savings rises upwards above the required level or its demand, rate of interest as a mechanism bring various forces into operation leading to a reduced saving desire there by rendering its supply to equal demand. Moreover, the rise in the rate of saving results into reduced interest rate which in turn affects the propensity for savings thus encouraging investment making the two to be at equilibrium.

References

Ahiakpor, J. C. (2015). A paradox of thrift or Keynes's misrepresentation of saving in the classical theory of growth?. Southern Economic Journal, 16-33.

Chenery, H., Lewis, J., De Melo, J., & Robinson, S. (2015). Alternative routes to development. In Modeling Developing Countries' Policies in General Equilibrium (pp. 179-215).

Dooley, M., Frankel, J., & Mathieson, D. J. (2007). International capital mobility: What do saving-investment correlations tell us?. Staff Papers, 34(3), 503-530.

Friedman, M. (2010). A theoretical framework for monetary analysis. journal of Political Economy, 78(2), 193-238.

Garegnani, P. (2008). Notes on consumption, investment and effective demand: I. Cambridge journal of Economics, 2(4), 335-353.

Hicks, J. R. (2007). Mr. Keynes and the" classics"; a suggested interpretation. Econometrica: Journal of the Econometric Society, 147-159.

Skidelsky, R. (2010). The relevance of Keynes. Cambridge Journal of Economics, 35(1), 1-13.

Westphal, U. (2013). ‘Domestic saving and international capital movements in the long run and the short run’by M. Feldstein. European Economic Review, 21(1-2), 157-159.

Wong, H. P. C. (2016). From the Treatise on Money to The General Theory: John Maynard Keynes's Departure from the Doctrine of Forced Saving. History of Political Economy, 48(3), 515-544.

Wray, L. R. (2010). Alternative theories of the rate of interest. Cambridge Journal of Economics, 16(1), 69-89.

Wray, L. R. (2012). Alternative theories of the rate of interest. Cambridge Journal of Economics, 16(1), 69-89.

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