Fig. 4.2). Given that supply is fixed then at any given quantity of money (M1) there will be a corresponding demand that varies inversely to the price level, i.e. a downward sloping demand curve and there will be an equilibrium price level that ‘clears the market’, i.e. demand equals supply. If the quantity of money is increased (M2) the demand curve will shift to the right, i.e. at the same price level demand will increase but, again, supply is fixed. A new equilibrium will be established at the same level of output but at a higher price level.
3.1.11 The Classical Theory of the Interest Rate
In the Classical theory, using the Cambridge approach, the interest rate (the price of money) measures the cost of holding cash. At a given level of k, individuals therefore have what is called ‘loanable funds’ (hence Keynes’ called the Classical Model of interest the ‘Loanable Funds Theory’. Beyond their need for money for transactional purposes, cash can serve as a store of value but yields no return so individuals will tend to hold their excess money in interest yielding securities. The Classical Model assumed that the rational individual would not hold excess money in the form of cash. Firms borrow funds from individuals in order to build new plant and equipment that eventually will increase Y. However, any investment is associated with a corresponding rate of return. A firm can only earn a profit on a given investment if its rate of return is greater than the opportunity cost of money, i.e. the interest rate. In the Keynsian Model the alternative investment opportunities formed a Marginal Efficiency of Investment Schedule with alternative projects ranked according to their estimated rates of return. Projects with rates above the interest rate would be undertaken while those with rates below the current interest rate would not (Fig. 4.3). Demand for loanable funds varies inversely with the interest rate. Similarly there is a supply of loanable funds...
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