Classical Theory Of Interest Rate Determination

Classical Theory Of Interest has been developed and refined by economists like Marshall, Pigou, Walrass and Knight. This theory is also known as the demand and supply theory of interest and savings. Investment theory of interest and real theory of interest.

According to Classical Theory Of Interest, the rate of interest is determined by the demand and supply of capital. The rate of interest is determined at the point where the demand for capital is equal to the supply of capital. The demand for capital arises from investment and the supply of capital springs from savings. Hence, the rate of interest is determined by savings and investment.

Demand for capital : The demand for capital arises on account of its productivity. Producers borrow capital for investment purposes. They pay interest for the investment of capital as it is productive. As more and more amount of capital invested in the production, the marginal productivity of capital diminishes. This is due to the operation of Law of Diminishing, Returns. The demand for capital depends upon the rate of interest. If the rate of interest is high, the demand for capital will be less. On the other hand, if the rate of interest is low, the demand for capital will be high. So, the demand curve for capital shows downwards from left to right.

Supply of capital : The supply of savings in the country is determined several factors including the rate of interest. Higher the rate of interest, higher shall be the volume of savings. Lower the rate of interest, lower shall be the volume
savings. If we want more savings, we have to pay high rate of interest. Hence, the supply curve of capital rises upward from left to right.

Determination of rate of interest : The rate of interest is determined at that point where the aggregate demand for capital is equal to the aggregate supply of capital. At this point says and investment will be equal. This is shown in the following diagram:

In the diagram DD is the demand curve for capital. SS is the supply curve of capital. Both intersect each other at point E OR represents the equilibrium rate of interest. It is the result of the equilibrium between the demand for and supply of capital.

Criticism of Classical Theory Of Interest:

This theory is criticized on the following grounds .
1. Full employment : The theory depends upon the assumption of full employment. But in reality full employment does not exist.

2. Level of Income: According to Keynes, the equality between saving and investment was brought about by the changes in the level of income and not by the rate of interest as stated by the classical economists.

3. Indeterminate: According to this theory, savings depend on the rate of interest but according to Keynes, saving depends on the level of income. The classical theory does not take the changes in the income level. Therefore, this theory is is indeterminate.

4. Monetary factor: This theory ignores the monetary factors in the determination of interest rate.

5. Changes in the interest rates : Savings may not increase when interest rises. When interest rises, the demand for investment falls. This results in a fall in the income level. When incomes fall savings will not increase.

6. Incomplete theory: Thus, the Classical theory is criticized as incomplete and indeterminate.