The Basic Concept of the State Monetary Policy - Term Paper Example

Lending money is the riskiest business because the future is never certain and continuously evolves and hence no one can see the future it is imperative that lenders get compensated for this uncertainty in the form of interest on the money that they are lending. Thirdly and lastly, the lender has to be compensated for the decrease in value of the money due to inflation, for example, a dozen eggs might cost 100rs today and after a year they might cost 110rs, so if I have loaned anyone 100rs I will want 110rs back because that is what 100rs is NOW worth or that is the equivalent value.

There are basically two theories that explain how interest rates are decided upon, one is the ‘Loanable Funds Theory’ also known as the classical theory and the other one is ‘Keynesian Theory’ also known as the liquidity preference theory. The loanable funds theory is the older one of the two theories and according to this theory the interest rates are determined by the demand for loanable funds by firms and the supply of these funds by the banking and other investment funds, it suggests that interest rates are determined in the same way as demand for other goods and services is determined i.e. by finding the equilibrium position of the demand and supply of the relative product.

Keynes pointed out to a whole new dimension with his liquidity preference theory, where he states that the demand and supply for money was not linked to current increases in capital and the saving levels of the economy but in his opinion, money should also be viewed as the ‘demand for money’ not in the sense that it needs to be spent but it needs to be held as an asset. These were the basics required to see what interest rates are and how they are determined and what makes them such a crucial element in the running of an economy on the whole.

Interest rates are a major tool of the monetary policy; monetary policy is basically the attempt to manipulate either the supply of money or the exchange rate to bring about the changes that are perceived by the state as the most favorable at a point in time.