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What determines the rate of interest?

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Introduction

What determines the rate of interest? In the UK interest rates, the base rate, gets set once a month by the Monetary Policy Committee at the Bank of England. Its sole remit is to achieve 2.5% inflation +/- 1%. Classical economics argue that simple supply and demand determines the rate of interest. ...read more.

Middle

The demand curve for loanable funds slopes downwards for the following reasons. Firstly, households will borrow more money at lower rates on interest and secondly it reflects the falling rate of return on investment as investment increases. The market will adjust to changes in supply and demand. If there is a rise in demand for capital equipment because of an improvement in technology that increases the productivity of capital, the demand for loanable funds to purchase this equipment will rise. ...read more.

Conclusion

This in turn will encourage more saving, the end result of which is that more money will be spent on capital equipment. It is important to mention, however, that some argue that savings do not respond to changes in interest rates because people save for a purpose i.e. to buy a house and they do not just save because the interest rate is high, thus the loanable funds theory is not necessarily an accurate description of how interest rates are determined. ...read more.

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