When individuals and businesses acquire loans from financial institutions, they pay an additional sum, which can be regarded as the cost of the loan that is borrowed. The additional sum that is usually in percentage is what is called interest rates. The interest rates in various countries are determined by various factors, including the market forces. Theorists have come up with theories that have attempted to answer how interest rates in an economy can be arrived at. In this paper, two major theories are compared. The two major theories are the Keynes theory and the classical theory. First, it would be crucial to understanding the important explanation of the theories on the issue of interest rates in an economy.
According to classical theory, interest rates in an economy are determined by the forces of demand and supply of savings and investments. Individuals and businesses borrow capital to invest and from the demand side, they borrow up to a point where the interest rates are equal to return on their investment. On the other hand, the people who save their money with the banks supply capital. They save with the expectation that the reward will be reasonable enough for the future consumption.
From the Keynesian perspective, money is demanded for transactionery, precautionary and speculative motives. As the interest rates rise, bond price decrease and people invest with the expectation that the prices will rise in the future. This means that they demand less of the money when the interest rates are high. On the other hand, the demand for money increases when the interest rates are very low. The supply for money by central bank is constant; hence, the demand for money is what mainly determines the level of interest rates.
Comparing the two theories, there are differences. First, the classical theory argues that savings is what motivates investments in the economy. On the other hand, Keynes theory supports the idea that investment leads to the generation of income, and the income is what is saved by businesses and individuals.
For the classical theory, interest rates are mainly determined by the loans in the banking sector. On the other hand, Keynesian theory considers that securities, bonds and long-term loans all play a role in influencing the interest rates in an economy.
The argument by classical theorists is that when the interest rates are high, then savings increase since the reward that results from saving is greater. For the Keynesian theory, high-interest rates mean a high cost of loans hence, fewer investments will be made. With fewer investments, income generated reduces hence savings also fall.
From the discussion, the classical and Keynesian theory of interest rates is very important in explaining how interest rates are arrived at in the economy. The theories are all important and give a guide to the financial regulators. The central banks have the role of influencing the interest rates in the economy so as to influence the growth of their economies. The policy makers are expected to understand the two theories because they all give a guide on how monetary policies are made. There is a need to use money supply from the central banks to influence the interest rates since the other factors such as savings and borrowing may not be influenced by other factors.
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