An important assumption of the neoclassical theory is that people have a "target" interest rate, the long-run target interest rate. This target real interest rate and the actual real interest rate interact to determine people's saving.

If the real interest rate exceeds the target interest rate, people save because the return on saving exceeds their target return. By saving, the stock of capital increases, and the supply of capital curve shifts rightward.

If the real interest rate is less than the target interest rate, people "dissave." That is, they have negative saving. They run down their past accumulated saving and spending more than their income. In this case, the nation's stock of cpaital decrease and the supply of capital curve shifts leftward.

If the real interest rate equals the target interest rate, people neither save nor dissave. The stock of capital does not change and so the capital supply curve does not shift.

Click on the figure below to return to the discussion of the neoclassical growth theory.

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