__INTEREST RATES IN THE CLASSICAL MODEL__

*Nominal vs.Real Interest Rates*
Real interest rate =Nominal rate - Inflation rate

r = r - p

**LOANABLE FUNDS**

**: those who are deficit spending units (specially those in business who want to invest) borrow.In the classical model, the desire to spend more depends negatively on the real rate of interest. As real rate of interest rises, cost of borrowing will be higher and therefore, less is borrowed.**

*Demand for 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. As real rates
rise, more current consumption are forgone for the higher future
consumption.

**EQUILIBRIUM INTEREST RATE**

*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.

Higher
real interest rates would have two effects:

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.

Since cost of borrowing has increased,
businesses will borrow and invest less, i2

**Equilibrium Interest rate**

*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

*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 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(**Purchasing Power Parity)

**E = P / P***

where:

P
= domestic price level

P* =foreign price level

E
= exchange rate

An increase in the domestic price level,
means higher E -- more dollars per foreign currency.

That is, depreciation of the dollar.