Discuss the role of the real forces of savings and investments in determination of interest rates.
Ans. Real savings refer to those parts of real incomes which are left unconsumed to provide resources for investment purposes.
Reinvestment implies use of resources in producing new capital assets like machines, factory plants, tools and equipment, etc. It means investment in capital goods industries, in real terms.
Demand for capital comes from entrepreneurs who wish to invest in capital goods industries. In fact, demand for capital implies the demand for savings.
Investors agree to pay interest on those savings because the capital projects, which will be undertaken with the use of these funds, will be so productive that the returns on investment realised will be in excess of the cost of borrowing, i.e., interest.
In short, capital is demanded because it is productive, i.e., it has the power to yield an income even after covering its cost, i.e., interest. The marginal productivity curve of capital, thus, determines the demand curve for capital.
Indeed the marginal productivity curve is, after a point, a downward sloping curve. While deciding about an investment, the entrepreneur, however, compares the marginal productivity of capital with the prevailing market rate of interest. Saving is the source of capital formation. Therefore, supply of capital depends basically on the availability of savings in the economy. Savings emerge out of the people’s desire and capacity to save.
To some classical economists like Senior, abstinence from consumption is essential for the act of saving while economists like Fisher stress that time preference is the basic consideration of the people who save.
In both the views, rate of interest plays an important role in the determination of savings. The classical economists commonly hold that the rate of saving is the direct function of the rate of interest.
The equilibrium rate of interest is determined at that point at which both demand for and supply of capital are equal. In other words, at the point at which investment equals savings, the equilibrium rate of interest is determined.
OR is the equilibrium rate of interest which is determined at the point at which the supply of savings curve intersects the investment demand curve, so that OQ amount of savings is supplied as well as invested.
This obviously implies that the demand for capital (OQ) is equal to the supply of capital (OQ) at the equilibrium rate of interest (OR).
Indeed, the demand for capital is influenced by the productivity of capital and the supply of capital. In turn, savings are conditioned by the thrift habits of the community.
Thus, the classical theory of interest implies that the real factor, thrift and productivity in the economy, are the fundamental determinants of the rate of interest.
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