What determines the rate of interest?

The rate of interest moves to bring demand for loanable funds into equilibrium with supply of savings. Supply for loanable funds represents accumulated savings. Demand for loanable funds on the other hand, is the demand for debt because firms have to borrow money to invest and thus will have accumulated a stock of debt. 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. The demand curve will shift to the right. The resulting shortage of funds will cause the rate of interest to rise. 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.