Venture Mechanics is an interesting group that brings a new perspective to the Angel Investor/Venture Capital model.  I am currently helping the partners and learning quite a bit.  I suggest taking a look at the site.

www.VentureMechanics.com

In the study of economics and finance there are several theories that attempt to explain how interest rates affect economies and how they can be used to forecast future changes. These theories include classical, liquidity reference, loanable funds and rational expectations theories. Each of these theories makes assumptions regarding the behavior of aspects of the economy and focuses on the behaviors of other aspects as determinants of the prevailing interest rates.

The classical theory of interest rates applies the classical theory of economics to determining interest rates. Classical theory of interest rates compares the supply of savings with the demand for borrowing. Using supply and demand curves the equilibrium rate is calculated by determining the curves intersection point. Thus if savings are greater than investments the interest rate drops until they reach equilibrium and vise versa, if savings are less than investment the interest rate increases until the reward for savings encourages increased savings rates causing the market to again reach equilibrium. However the classical theory of interest rates fails to account for factors besides supply and demand that may affect interest rates such as the creation of funds, the importance of income and wealth and changes in the primary borrowers in an economy.

A second method of determining interest rates is the liquidity preference theory. Liquidity preference theory asserts that economic units have a preference for liquidity over investing. Applying this theory explains the premium offered in forward rates in comparison to expected future spot rates. This premium is used as payment for the use of scarce liquid resources. The preference for liquidity can be accounted for by the fact that economic units need to hold certain levels of liquid assets for purchase of goods and services and the fact that these near term future expenditures can be difficult to predict. Liquidity theory is limited by its short-term nature, the assumptions that income remains stable, and, like classical theory, only supply and demand for money are considered.

Loanable funds theory assumes that interest rates are determined by supply of loanable funds and demand for credit. In loanable funds theory the demand of loanable funds originates from domestic business, consumers, governments and foreign borrowers. While the supply is generated by domestic savings, dispersion of money balances, money creation in the banking system and foreign lending. With these factors determining long-term interest rates, short term interest rates are decided by financial and monetary conditions in the economy. The many factors considered in loanable funds theory mean that equilibrium will be reached only when each of the factors is in equilibrium.

The rational expectations theory of interest rates is based on the idea that people formulate expectations based on all the information that is available in the market. Rational expectation theory holds that the best estimation for future interest rates is the current spot rate and that changes in interest rates are primarily due to unexpected information or changes in economic factors. The rational expectations theory can be incorporated with the loanable funds theory in order to better consider the available information with the economy. The limiting factors of rational expectation theory are mostly related to the difficulty in gathering information and understanding how the public uses its information to form its expectations.

All of the described theories have shortcomings in some aspect. These limitations are based on the theories’ various assumptions which are necessary to understand the diverse aspects of economic influence and change. The most inclusive of these theories is the loanable funds theory and as such it is the choice of financial practitioners. The loanable funds theory includes many of the various factors that influence our markets. Because of the variety of influences included in the theory, any failure can be attributed to imbalances in the equilibrium of savings and investment, money supply and demand, the supply of loanable funds, or net foreign demand and exports.