Interest Rates in the Classical Model
Nominal vs.. Real Interest Rates
Real interest rate =Nominal rate - Inflation rate

=
r

Loanable Funds
Demand for funds: those who are deficit
spending units (specially those in business
who want to invest) borrow.
Loanable Funds
Demand for funds: those who are deficit spending units (specially those in
In the classical
model, the desire to spend more
depends negatively on the real rate of
interest.
business who want to invest) borrow.
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
As real
rate of interest rises, cost of borrowing
will be higher and therefore, less is
borrowed.
spend more depends negatively on the real rate of interest.
Loanable Funds
Supply of Loanable funds come from those
who are surplus spending units.
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.
Loanable Funds
Supply of Loanable funds come from those who are surplus spending units.
As
real rates rise, more current consumption
are forgone for the higher future
consumption.
Supply of funds are positively related to the real rate of interest rates.
Equilibrium Interest rate
 =r- 
S

I
I, S
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.
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
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.
rates.
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
Equilibrium Interest rate
 =r- 
S
2
1
I’
G - T
I
I, S
i2
i1
i2+G-T
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.
Equilibrium Interest rate
 =r- 
S
S’
t-g
1
2
I
I, S
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.
Purchasing Power Parity
Exchange rate is the value of one currency in
terms of another.
Purchasing Power Parity
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.
Exchange rate is value of one currency in terms of another.
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.
PPP
E = P / P*
where:
P = domestic price level
P* =foreign price level
E = exchange rate
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.