The Classical Theory of Interest

This theory is also known as the real theory of interest because it states that the interest rate is determined by real factors.
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 The Classical Theory of Interest with Criticisms

The theory of interest propounded by classical economists is called the classical theory of interest. This theory is also known as the real theory of interest because it states that the interest rate is determined by real factors such as investment and savings. This theory is also known as the demand and supply theory of savings. 

J.M. Keynes said, "The classical theory of interest is the savings-investment theory."

According to this theory, the interest rate is the price paid for savings invested as capital. The interest rate is determined by the interaction of investment and savings. 

The classical theory of interest has been presented in a refined form by economists such as Alfred Marshall, Arthur Cecil Pigou, and Frank William Taussig. 

This theory can be explained under the following headings:

(a) Investment Demand

Entrepreneurs demand investment with the intention of investing in capital goods. The amount of investment depends on the marginal productivity of capital and the interest rate. If the marginal productivity of capital is higher than the interest rate, then it is beneficial for entrepreneurs to increase investment in capital goods. However, as entrepreneurs gradually increase the amount of investment in capital goods, the marginal productivity of capital decreases. Entrepreneurs continue to increase investment until the interest rate decreases and becomes equal to the marginal productivity of capital.

Thus, given the marginal productivity of capital, as the interest rate decreases, entrepreneurs increase investment in capital goods. In other words, investment increases when the interest rate decreases. Therefore, there is an inverse relationship between the interest rate and investment demand. The investment demand curve, which shows the inverse relationship between the interest rate and investment demand, slopes downward from left to right or has a negative slope.

(b) Supply of Savings

People save a portion of their income with the aim of solving future emergencies or with the aim of earning interest by supplying it in the market. Savings made for investment or the supply of savings depends on the interest rate. The supply of savings increases when the interest rate increases, and the supply of savings decreases when the interest rate decreases. Thus, there is a positive or direct relationship between the interest rate and the supply of savings. This gives a positively sloped savings supply curve.

(c) Determination of Interest Rate

According to the classical theory of interest, the equilibrium interest rate is determined by the interaction of investment demand and savings supply. The equilibrium interest rate determination process is explained below with the help of a hypothetical table.

Table 3.1: Classical Theory of Interest

Interest Rate (in %)Investment Demand (Rs.)Supply of Savings (Rs.)
225050
3200100
4150150
5100200
650250

In Table 3.1, as the interest rate increases from 2% to 6%, the investment demand decreases from Rs. 250 to Rs. 50, and the supply of savings increases from Rs. 50 to Rs. 250. The investment demand and supply of savings are equal, i.e., Rs. 150, when the interest rate is 4%. Therefore, 4% is the equilibrium interest rate.

The interaction of investment demand and savings supply or the equilibrium interest rate determination process under the classical theory of interest can also be explained with the help of Figure 3.1. 

Figure 3.1: Classical Theory of Interest Determination

classical-theory-of-interest-graph
In Figure 3.1, investment demand and savings supply are measured on the X-axis, and the interest rate is measured on the Y-axis. The investment demand curve is denoted by II, and the savings supply curve is denoted by SS. These two curves intersect each other at point E. Therefore, point E is called the equilibrium point.

Here, the equilibrium interest rate is 4%, and the investment demand and supply of savings are determined to be Rs. 150. If the market interest rate is higher than the equilibrium interest rate (4%), the supply of savings exceeds the investment demand, and the interest rate starts to decrease. The process of the interest rate decreasing continues until the investment demand and supply of savings become equal. 

Similarly, if the market interest rate is lower than the equilibrium interest rate (4%), the investment demand exceeds the supply of savings, and the interest rate starts to increase. The process of the interest rate increasing continues until the investment demand and supply of savings become equal. 

Thus, 4% is the equilibrium interest rate because it equates the investment demand and supply of savings in the market, i.e., Rs. 150. In this way, according to the classical theory, the equilibrium interest rate is determined when investment and savings are equal.

Criticisms of the Classical Theory of Interest

J.M. Keynes and other economists have criticized the classical theory of interest on various grounds. Some of the main criticisms are presented below:

  1. According to J.M. Keynes, interest is not the price of savings made for capital investment, as stated by classical economists, but rather the reward for parting with liquidity.

  2. Classical economists have stated that the interest rate equates savings and investment. However, J.M. Keynes has expressed the view that it is the change in the level of income, not the interest rate, that equates savings and investment.

  3. The classical theory of interest is based on the unrealistic assumption of full employment equilibrium. However, according to J.M. Keynes, the state of full employment equilibrium is difficult to find in real life.

  4. According to the classical theory of interest, the interest rate is determined by real factors such as investment and savings. However, according to J.M. Keynes, the interest rate is a monetary concept. It is determined by monetary factors such as the demand for money and the supply of money.

  5. The classical theory of interest states that savings are made only for investment purposes, but people also save for consumption purposes. This aspect is not covered by the classical theory of interest.

  6. The classical theory of interest considers savings from current income as the only source of investment, but critics argue that past savings and bank loans also play a role as sources of investment in addition to current savings.

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