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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. They came up with the loanable funds theory. The diagram below shows the loanable funds theory. 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...

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