Classical Theory of the Interest Rate

Classical Theory of the Interest Rate

• AD: consumption, investment, and

government spending determine the rate of
interest
• Equilibrium rate of interest: demand for
loanable funds= supply of loanable funds
Classical Theory of the Interest Rate
 Classical Theory of the Interest Rate

Basic assumptions:
• Borrowers are business firms and government
• Business firms borrow by issuing bonds
(perpetual bonds)
• Governments borrow to the extent of their
budget deficit (R-E) by issuing bonds
 Classical Theory of the Interest Rate

• Rate of interest: returns on holding bond (for

the lender) or the cost of borrowing (for the
borrower)
• The rate of interest depends on the factors that
determine borrowing (supply of bonds) and
lending (demand for bonds)
• Supply of bonds:
• Demand for bonds
 Classical Theory of the Interest Rate

• Supply of bonds
- Government: level of deficit and deficit
financing decision of the government
- Level of deficit depends on taxation and
expenditure
- Deficit financing depends on ability of the
government to impose additional taxes and cut
down on expenditure
 Classical Theory of the Interest Rate

Supply of bonds
- Business investment: expected profitability of
investment projects and the rate of interest
- Expected profitability depends on varying
expectation of demand for products during the
life of the assets
All are factors exogenous to the classical model
 Classical Theory of the Interest Rate

Supply of bonds

• For a firm, expected profitability of an investment is inversely

related to the rate of interest
-A firm may have several investment projects with varying expected
rates of return
-The firm will select the project with highest rate of return
assuming that all other factors are given, at higher interest rate, there
will be fewer projects will be profitable (interest is a cost)
-There will be fewer projects to choose from
-At lower interest rate, more and more projects will become profitable
- Inverse relationship between rate of interest and borrowing to finance
investment projects
 Classical Theory of the Interest Rate

Supply of bonds
• Government bond supply is exogenous, and
the business supply of bonds equals the level
of investment expenditure
 Classical Theory of the Interest Rate

Demand for bonds

- Savers
- Savings are directly related to the rate of interest
- Savings involves sacrifice of present consumption
- At higher rate of interest the trade off between
present consumption and future returns becomes
more and more favourable to the saver
 Classical Theory of the Interest Rate

- Savings need not always be lent

- Can be held in the form of other assets (some
income earning and others non –income
earning but wealth creating)
- But classical economists assumed that
additional saving will be used to lend
- However, during severe financial crisis, people
may only hold cash and not bonds and other
forms of wealth (liquidity trap?)
 Classical Theory of the Interest Rate

• Equilibrium rate of interest is determined by

the intersection of demand for laonable (I =
supply of bonds) funds and supply of loanable
funds (S = demand for bonds)
• G-T – deficit which is exogenously determined
• Interest rate R0 is the equilibrium rate of
interest
• What will happen to interest rate if
government budget is balance?
 Classical Theory of the Interest Rate
• Interest rate plays a stabilizing role in the classical
system
• Effects of a change in expected profitability of
investment
• In the short run investment depends upon rate of
interest and expected rate of profitability
• If due to some exogenous factor (pandemic) businesses
lower their expected rate of profitability of investment:
reduction in investment
• Reduced demand for loanable funds at different levels
of interest rates
• The demand curve will shift to the left
Classical Theory of the Interest Rate
 Classical Theory of the Interest Rate
• Shift of demand curve represents autonomous
decline in investment
• Let us assume the G = T and there is no
borrowing by government (no government
demand for loanable funds)
• Investment is the only source of demand for
loanable funds
 Classical Theory of the Interest Rate
• At R0 rate of interest, supply of loanable funds will
exceed demand for loanable funds
• This will put downward pressure on the rate of interest
• The rate of interest declines to adjust demand and
supply
• As rate of interest declines
- a) savings (S) decline and consumption (C) increases
(Decline in S = increase in C)
- Investment is increased to some extent due to decline
in rate of interest (not entirely because investment is
also determined by expected rate of profit)
 Classical Theory of the Interest Rate
• New equilibrium rate of interest R1
- The increase in consumption Δ C + Δ I = original
autonomous decline in investment Δ I
• Because of the adjustment of the interest rate, the sum
of private-sector demands (C + I) is unaffected by the
autonomous decline in investment demand
• Demand for output as a whole is not affected by
change in investment
• Due to adjustment in rate of interest rate
• Maintain full employment
 Classical Theory of the Interest Rate
• Aggregate demand curve will not change
• Even if it does, there would be no change in
output and employment due to vertical aggregate
supply curve (labour market flexibility)
• Full employment equilibrium: maintained due to
- First line of defense: interest rate adjustment
- Second line of defense: labour market
adjustment
 HDFC Bank
• June quarter operational data
• Second wave of COVID
• Y-o-Y and sequential
• 14% growth in overall advances Y-o-Y
• 1.3% sequentially
• Retail assets (loans)- shrink by 30% sequentially
• Retail’s share of total loans down to 45% from
47%
• Retail assets has been the strength of HDFC Bank
 HDFC Bank
• Retail loan recovery expected to be delayed
• Non-retail loans, commercial and rural loans
increased by 25% and 11% respectively
• Corporate loans increased by 17% YoY
• Weaknesses: SME, commercial vehicles, and
personal loans (default risks)
• Deposit growth: 13% YoY
• CASA deposits: growth 28% YoY
• Term deposits retail segment : growth 17%
 HDFC Bank
• CASA deposits expected to grow continuously
• How will this help the bank?
• Impact on interest rate going forward
 Food Inflation
• Food inflation is looming large
• RBI’s policy dilemma
• Inflation or growth?
• Food inflation expected
- Slowing monsoon
- Delayed sowing
• Monetary policy expectation: no change in
rates
 Food Inflation
• Total crop area shrunk from 25.9 million
hectares to 20. 3 million hectares (delayed
sowing)
• Growth is affected due to second wave
• The economy will have to tolerate the
inflation
• Food inflation may be moderated through
imports (record high forex reserves)
 Food Inflation
• MPC has factored in a decline in food prices
• Food inflation fell 2.7% in April from 5.2% in
March
• Prices of sugar, cereals and vegetables
declining
• FSR published last week: rising global food
prices
• Global Food Price Index rose by 40% in April to
the highest level since May 2014
 Food Inflation
• Global food price trend rising in case of milk,
sugar, oils, meat, cereals
• Will affect prices of processed and packaged
food
• Increase in global prices due to increased
commodity prices, shipping charges,
normalisation of taxes and tariffs
• https://openknowledge.worldbank.org/bitstre
am/handle/10986/34593/Inflation-Targeting-
in-India-An-Interim-
Assessment.pdf?sequence=1&isAllowed=y
• https://www.rbi.org.in/Scripts/PublicationRep
ortDetails.aspx?UrlPage=&ID=1178
• https://tradingeconomics.com/india/interest-
rate