4. In the classical theory of interest rates, what forces determine the market rate of interest? What assumptions does the classical theory of interest rest upon?
Answer: In the Classical theory of interest rates, the major forces that determine the market rate of interest are the demand for investment and the volume of saving. Limitations/Assumptions of the Classical theory of interest include the ignoring of factors other than saving and investment that affect interest rates. For example, many financial institutions have the power to create money today by making loans to the public. When borrowers repay their loans, money is destroyed. The volume of money created or destroyed affects the total amount of credit available in the financial system and, therefore, must be considered in any explanation of interest rates. The Classical theory of interest also assumes that interest rates are the principal determinant of the quantity of savings available. However, economists recognize today that income is actually more important in determining the volume of saving.