Question

Explain why the supply curve in the Classical theory of interest rates has a positive slope? Why does the demand curve in the Classical theory have a negative slope?

Answer 1

Classical Theory of Interest:

According to this theory, interest is the reward for use of capital. The supply curve is a positive function of interest rate and the demand curve is a negative function of the interest rate.

The rate of interest is a force which brings equilibrium between saving and investment. When there is supply of savings, it means there is a flow of funds into the capital market, and so the interest rate rises. When there is demand for investment, there is flow of funds out of the capital market, and so the interest rate falls. This is why supply curve has positive slop and demand curve has negative slope.

According to this theory, when there is disequilibrium for example when saving exceed investment, the interest rate falls, thereby increasing demand for investment until there is equilibrium between saving and investment.  Whereas, if investment exceeds saving the rate of interest increases,thereby increasing the savings in the market and bringing equilibrium between savings and investment.