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The Interest Rate in a Monetary Economy

Kehrwald, Bernie (2014): The Interest Rate in a Monetary Economy.

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Abstract

Major central banks have pointed out that basic economic models describe the monetary system inaccurately. In this context, the current paper presents a model of interest rate determination based on a sound description of the monetary system. Its novelty is providing an alternative credit supply function that represents planned savings. Further, the model is compared with three standard theories. The main conclusions are threefold. First, under certain assumptions, the viewpoint of loanable funds theory that the interest rate balances savings and investments can be reconciled with a monetary economy. However, the balancing process is not a market mechanism. Loanable funds theory must therefore be reinterpreted. Second, liquidity preference theory is insufficient to explain the interest rate level in a modern monetary economy. Third, endogenous money theory describes a monetary economy correctly in principle, but it is incomplete without the above-mentioned credit supply function.

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