Classical Theory Vs Interest Rate Theory

According to the Investopedia website, the term Interest rate is the amount charged, expressed as a percentage of principal , by a lender to a borrower for the use of assets . Interest rates are usually noted every year. This is known as the annual percentage rate (APR). Interest is fundamentally a leasing charge to the borrower, for the asset's use. In the case of a large asset, for instance, a vehicle or building, the interest rate is known as the "lease rate". There are two basic theories in interest rate determination. The first is the classical theory developed by economists in the nineteenth and eighteenth century and the second is the liquidity preference theory developed by Lord John Maynard Keynes in the twentieth century. The

Keynes’ theory generally considers the supply of cash at any one time is relatively constant. Therefore the supply curve is a straight vertical line. Oppositely, the Classical theory, relates the supply curve to the amount of money supplied by those who own the funds, the savers. The higher the rate, the more that saver will be willing to forego the use of their money. The demand curve in the classical theory, focuses on the need for funding for investment purposes or consumption of resources by consumers and producers. Similarly the demand of money is based on the needs for funding. Keynes states that there are three combination of motives behind the public's desire to hold liquid cash. Firstly, the transaction motive, which relates to the demand of monies for current transactions and business exchanges. Secondly, the precautionary motive. This is holding cash incase of illnesses or other emergencies. Lastly, the speculative motive, this relates to persons wanting to hold resources in liquid form in order to be able to take advantage of any changes in the future rate of interest or bond

The Classical theory states that the higher are income levels, the more savings will become available. On a graph, this means that the supply of money shifts to the right. On the other hand, the Liquidity theory states that the transactionary and precautionary functions are relatively constant but the speculative motive is inversely related to interest rates where the higher the interest rate, the less that a saver will prefer to be liquid in his cash holdings. The Central Bank has the ability to keep the money supply constant and the transactionary and precautionary demand for money is also relatively fixed, the speculative demand increases as income increases. This is so because when the income increases, there are now more funds available for speculative purposes. As with the classical theory, in the liquidity preference theory, the underlying factor that will cause shifts in demand and supply curves is income