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Interest Rates in the Classical Model

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As real rate of interest rises, cost of borrowing will be higher and therefore, ... Higher real interest rates would have two effects: ... – PowerPoint PPT presentation

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Title: Interest Rates in the Classical Model


1
Interest Rates in the Classical Model
  • Nominal vs.. Real Interest Rates
  • Real interest rate Nominal rate - Inflation
    rate
  • ? r - ?

2
Loanable Funds
  • Demand for funds those who are deficit spending
    units (specially those in business who want to
    invest) borrow.

3
Loanable Funds
  • Demand for funds those who are deficit spending
    units (specially those in business who want to
    invest) borrow.In the classical model, the desire
    to spend more depends negatively on the real rate
    of interest.

4
Loanable Funds
  • Demand for funds those who are deficit spending
    units (specially those in business who want to
    invest) borrow.In the classical model, the desire
    to spend more depends negatively on the real rate
    of interest. As real rate of interest rises,
    cost of borrowing will be higher and therefore,
    less is borrowed.

5
Loanable Funds
  • Supply of Loanable funds come from those who are
    surplus spending units.

6
Loanable Funds
  • Supply of Loanable funds come from those who are
    surplus spending units. Supply of funds are
    positively related to the real rate of interest
    rates.

7
Loanable Funds
  • Supply of Loanable funds come from those who are
    surplus spending units. Supply of funds are
    positively related to the real rate of interest
    rates. As real rates rise, more current
    consumption are forgone for the higher future
    consumption.

8
Equilibrium Interest rate
? r- ?
S
?
I
I, S
9
Interest Rates and Government Deficits
  • Government is a big borrower in the market. When
    they run a deficit, they usually borrow. This
    means higher demand for Loanable funds and higher
    interest rates.

10
Interest Rates and Government Deficits
  • Government is a big borrower in the market. When
    they run a deficit, they usually borrow. This
    means higher demand for Loanable funds and higher
    interest rates.Higher real interest rates would
    have two effects
  • 1-- private saving increases while private
    consumption decreases. (remember that in the
    classical model income is fixed. People can
    change the composition of their S/C.

11
Interest Rates and Government Deficits
  • Government is a big borrower in the market. When
    they run a deficit, they usually borrow. This
    means higher demand for Loanable funds by the
    amount of deficit and therefore higher interest
    rates. Higher real interest rates would have two
    effects
  • 1-- private saving increases while private
    consumption decreases. (remember that in the
    classical model income is fixed. People can
    change the composition of their S/C.
  • 2-- Since cost of borrowing has increased,
    businesses will borrow and invest less, i2

12
Equilibrium Interest rate
? r- ?
S
?2
?1
I
G - T
I
I, S
i2
i1
i2G-T
13
Equilibrium Interest rate and Government Surplus
  • In contrast to the case where there is a deficit,
    a government surplus adds to the supply of
    loanable funds.

14
Equilibrium Interest rate
S
? r- ?
t-g
S
?1
?2
I
I, S
15
Monetary and Interest Rates
  • In the classical model, Saving and Investment are
    real variables and not affected by the monetary
    policy. Higher money supply determines inflation
    rate and therefore higher nominal interest rates
    -- not real interest rates.

16
Purchasing Power Parity
  • Exchange rate is the value of one currency in
    terms of another.

17
Purchasing Power Parity
  • Exchange rate is value of one currency in terms
    of another. In a perfect world, if there are
    discrepancies among prices around the world,
    arbitrage will equalize them. So value of one
    currency in terms of another does not change.

18
Purchasing Power Parity
  • Exchange rate is value of one currency in terms
    of another. In a perfect world, if there are
    discrepancies among prices around the world,
    arbitrage will equalize them. So value of one
    currency in terms of another does not change.
    However, if there is persistent inflation in one
    country, one currency loses its purchasing power
    and therefore loses its value relative to another
    currency and it must depreciate.

19
PPP
  • E P / P
  • where
  • P domestic price level
  • P foreign price level
  • E exchange rate

20
PPP
  • E P / P
  • An increase in the domestic price level, means
    higher E -- more dollars per foreign currency.
    That is, depreciation of the dollar.
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