refers to expenditures on capital goods, and the marginal productivity of investment refers to the internal rate of return, or break-even point, for a capital investment (Ekelund & Hebert, 1990, p. 142). Thus, if the interest rate at which funds are available were lower than the internal rate of return for a capital investment, businesses would expect that a profit could be earned on the investment. Hence, the demand for funds would be expected to increase. Conversely, if the interest rate at which funds are available were higher than the internal rate of return, the demand for funds would be expected to decrease.
Time preference theory in economics holds that, other factors being neutral, individuals prefer current consumption to future consumption (Ekelund & Hebert, 1990, p. 169). Given such a time preference for current consumption, some inducement must be offered to individuals to cause them to save, which is the equivalent to deferring consumption. A major inducement for savings in a capitalist economy is interest. As the interest rate is increased, the willingness to save will, in theory, increase, and, as the interest rate is decreased, the willingness to save will, in theory, decrease. Thus, as the willingness to save increases, the supply of loanable funds increases, and vice versa.
Classical economic theory held that the rate of interest is determined by the intersection of investment demand and the level of saving (Ekelund & Hebert, 1990, p. 178). This intersection, thus, described the relationship between savings and investment, as a combined variable, and the rate of interest. Within the context of classical economic theory, therefore, the rate of interest brought savings into equilibrium with investment in the economy. If interest rate levels offered on savings attracted savers, the quantity of loanable funds would increase to a point where interest rate levels offered on borrowings would be lowered to ...