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Classical theory of interest or real theory of interest

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The classical theory of interest or real theory of interest:-

The theory of interest propounded by classical economists is known as the classical theory of interest. It is also known as the real theory of interest because it explains the determination of interest rate by the real factors i.e. demand for saving and supply of saving. According to classicists, the rate of interest is the price paid for saving to invest in capital and it is determined by the forces of productivity and thrift. The interaction between the downward sloping demand curve for saving and upward-sloping supply curve of saving determines the rate of interest.

The classical theory of interest is based on the following assumptions:-
  • There is full employment of factors of production.
  • Demand for saving to invest inversely varies with the rate of interest.
  • Supply of saving positively varies with the rate of interest.
  • Law of diminishing returns operates on the marginal productivity of capital.
  • Demand for saving is raised up to the point where marginal productivity of capital equals the rate of interest.
  • Saving depends on the capacity and willingness to save.
  • Level of income is given.
  • Money works only as a medium of exchange and it has no other effects.
The classical theory of interest can be explained under the following headings:-

1. Demand for saving:-
Demand for saving arises from the desire of entrepreneurs to invest in capital goods. The desire for investment in capital goods depends on the marginal productivity of capital and the rate of interest. It will be profitable for entrepreneurs to invest in capital goods as the rate of interest falls. Therefore, there exists an inverse relationship between the rate of interest and demand for saving. This will give the downward sloping curve for the saving.

Symbolically,
D=F(r) and f' < 0

2. Supply of saving:-
The supply of saving comes from individuals' saving. It is a surplus income over consumption. Individual save their part of income for their future reference or to get reward by supplying saving volume in the market. The volume of saving depends on the rent of interest. At the higher level of interest, there will be a higher supply of saving and vice-versa. So, it gives positively sloped supply curve of saving.

Symbolically,
S=F(r) and f' > 0

According to the classical theory of interest, the equilibrium rate of interest is determined by the interaction of demand for saving and supply of saving for interest. The process of determination of the equilibrium interest of rate can be explained by the help of following schedule and diagram:-

Rate of interest ®
Demand for saving (Ds)
Supply of saving (Ss)
Remarks
3%
Rs. 15000
Rs. 5000
Ds > Ss
5%
Rs. 10000
Rs. 10000
Ds=Ss
7%
Rs. 5000
Rs. 15000
Ds < Ss
Classical-theory-of-interest


In the above schedule and diagram, we can see that when the rate of interest increases, people are willing to supply more saving to invest and at a low rate of interest they will supply less. But at the low rate of interest, demand for saving is high and vice-versa. The interest rate is determined at that point where the demand for saving and supply of saving are equal. In the diagram above, ‘e’ is the equilibrium point where demand for and supply of saving interact with each other. The interest rate here is determined at 5%.

Criticisms of the classical theory of interest:-

1. Interest is not the price paid for saving to invest :-
According to the classical theory, interest is the price paid for saving to invest in capital. But, Keynes defines interest as the reward for parting with liquidity.

2. Rate of interest does not bring equality of saving in investment :-
The classical theory of interest says that the change in the rate of interest brings about the equality of saving and investment. But, Keynes opines that the equality between saving and investment is brought by the change in the level  of income.

3. Unrealistic assumption of the full employment equilibrium :-
The classical theory of interest is based on the assumption of the full employment equilibrium. However, Keynes views that the full  employment equilibrium is the abnormal situation and cannot be found in the real world.

4. Indeterminate theory:-
Keynes has remarked the classical theory of interest as indeterminate theory. Since saving depends upon the level of income, it is not possible to know the rate of interest unless the level of income is known beforehand. Lower interest rate will increase the volume of investment and thereby increases output, employment, income and saving. The classical theory of interest has no solution for this. So, it is indeterminate theory.

5. Narrow in scope :-
The classical theory assumes that saving is only used for investment purpose. However, saving is also used for consumption, transaction, precautionary and other purposes. So, classical theory of interest is narrow in scope.

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