Question

In the classical theory, money doesn’t alter the rate of interest. Explain if this statement is true using the loanable funds theory

Answer 1

True.According to classical theory money does not alter the rate of interest.In classical theory monetary policy will not have an effect on the real variables such as interest rate,consumption ,savings,investment etc...
In classical theory demand and supply of savings are the major determinants that alter the rate of interest .This can be explained using the loanable funds theory.

In loanable funds theory interest rate is determined by the demand and supply of loanable funds.Loanable funds includes savings also.Loanable fund theory is actually an extension of the classical theory.If the supply of loanable funds increases it implies that there is increased savings and the rate of interest will decrease. where as when the demand for loanable funds increase the rate of interest will increase.

This is shown in the diagram given below.
The first diagram shows the shift of the supply curve of the loanable funds.When the supply of loanable funds increases there is increased savings and supply curve shift from s¹ to s² but rate of interest decreases from r¹ to r² as shown in the figure.

The second diagram shows the shift in the demand of loanable funds when there is an increased demand for loanable funds the demand curve will shift from d¹ to d² and the rate of interest increases from r¹ to r².

Thus to conclude it is the demand and supply that alter the interest rate and it's not the money that alter the rate of interest.