ABSTRACT
Wicksellian monetary theory of interest rates suggests that the real rate of interest is the rate that equilibrates the demand for and supply of capital or loanable funds. The loanable fund market is described by a negatively sloped demand curve which reflects the diminishing marginal productivity of capital in industrial use and a positively sloped supply curve which represents the rate of savings available in the market. The rate of interest at which supply equals demand is referred to as the natural rate and is assumed to be determined by real forces of productivity and thrift. Using the loanable fund framework, assume that there is an exogenous decline (increase) in the marginal efficiency of capital. This causes the demand curve to shift downward (upward) causing the natural rate to fall (rise). Any attempt to prevent the market rate of interest from falling will result in a deflationary gap which causes income and employment to fall, resulting in a shift of the supply curve for funds. The fall in the supply of funds results in a fall in the market rate of interest towards its natural rate. As long as the interest rate stays above its natural rate, the unemployment rate stays above its natural level. In general, in the short-term, interest rates can deviate from their long-run equilibrium rate which is determined by the real forces in the economy, but in the long run they converge to the natural rate.
