In this article we will discuss about the classical theory of interest with its criticisms.
According to the classical theory, rate of interest is determined by the supply of and demand for capital. The supply of capital is governed by the time preference and the demand for capital by the expected productivity of capital. Both time preference and productivity of capital depend upon waiting or saving or thrift. The theory is, therefore, also known as the supply and demand theory of saving.
The demand for capital consists of the demand for productive and consumptive purposes. Ignoring the latter, capital is demanded by the investors because it is productive. But the productivity of capital is subject to the law of variable proportions. Additional units of capital are not as productive as the earlier units.
A stage comes, when the employment of an additional unit of capital in the business is just worthwhile and no more. Suppose, an investor invests Rs.1,00,000 in a factory and expects, a yield of 20%. Another instalment of an equal amount would not be as productive as the first one and might bring him 15%. While a third instalment might yield 10%.
If he has borrowed the money at 10%, he will not venture to invest more. For the rate of interest is just equal to the marginal productivity of capital to him. It shows that at a higher rate of interest, the demand for capital is low and it is high at a lower rate of interest.
Thus the demand for capital is inversely related to the rate of interest, and the demand schedule for capital or investment curve slopes downward from left to right. There, are, however, certain other factors which govern the demand for capital, such as the growth of population, technical progress, process of rationalization, the standard of living of the community, etc.
The supply of capital depends upon savings, rather upon the will to save and the power to save of the community. Some people save irrespective of the rate of the interest. They would continue to save even if the rate of interest were zero. There are others who save because the current rate of interest is just enough to induce them to save.
They would reduce their savings if the rate of interest fell below this level. Still there are the potential savers who would be induced to save if the rate of interest were raised. To the last two categories of savers, saving involves a sacrifice, abstinence or waiting when they forgo present consumption in order to earn interest.
The higher the rate of interest, the larger will be the community savings and the more will be the supply of funds. The supply curve of capital or the saving curve thus moves upward to the right.
Assuming the level of income to be given, the rate of interest is determined by the interaction of the demand curve and the supply curve of saving. This is shown in Figure 1 where I and S curves intersect at E which is the equilibrium point when OQ quantity of capital is demanded and supplied at R rate of interest.
If at any time the rate of interest rises above R, the demand for investment funds will fall and the supply of savings will increase. Since the supply of savings is more than the demand (R1s>R1 d), the rate of interest will come down to the equilibrium level OR. The opposite will be the case if the rate of interest falls to R2.
The demand for investment funds is greater than the supply of savings (R2d1>R2s1) rate of interest will rise to R. The ultimate situation is one of equality between saving and investment brought about by the equilibrium or the natural rate of interest.
If at any time people become thrifty and save more than OQ, the rate of interest would fall below R because the demand for capital remains the same. This is shown by the downward shift of the saving curve to S1, where it intersects the I curve at d, and the rate of interest falls to R2 At the lower rate of interest, people will save less but the demand for investment funds will increase which will tend to raise the rate of interest to the equilibrium level R.
Criticisms of the Classical Theory of Interest:
The ‘pure’ or the real theory of interest of the classicals, as enunciated by Marshall and Pigou, has been severely criticised by Keynes.
(1) Income not Constant but Variable:
One of the serious defects of the classical theory is that it assumes the level of income to be given, and regards interest as an equilibrating mechanism between the demand for investible funds and the supply of funds through savings. According to Keynes, income is a variable and not a constant and the equality between saving and investment is brought about by changes in income and not by variations in the rate of interest.
(2) Saving-Investment Schedules not Independent:
In this theory the two determinants of interest rate, the demand and supply curves of saving are treated as independent of one another. It means that if there is change in demand, the demand curve for savings can shift up or below the I curve without causing a change in the supply curve.
But according to Keynes, the two curves are not independent of one another. If, for instance, an invention shifts the investment curve upward, income will rise and it will lead to higher savings and thus shift the supply curve too. Similarly, a shift in the supply curve will bring a change in the demand curve.
(3) Neglects the Effects of Investment on Income:
The classical theory neglects the effect of investment on the level of income. A rise in the rate of interest, for instance, will bring a decline in investment by making it less profitable. This will mean decline in output, employment and income. The latter will, in turn, lead to reduced savings, a fact contrary to the classical assertion that saving is a direct function of the rate of interest.
On the other hand, a low rate of interest encourages investment activity, increases output, employment, income and savings. But Keynes does not believe that investment depends on the rate of interest. It depends on the marginal efficiency of capital. Even if the rate of interest were to fall to zero, Keynes argues, investment will not take place if business expectations for profits are at a low level, as is the case in depression.
(4) Indeterminate Theory:
Since savings depend upon the level of income, it is not possible to know the rate of interest unless the income level is known beforehand. And the income level itself cannot be known without already knowing the rate of interest.
A lower rate of interest will increase investment, output, employment, income and savings. So, for each income level a separate saving curve will have to be drawn. This is all circular reasoning and offers no solution to the problem of interest. That is why Keynes characterised the classical theory of interest as indeterminate.
(5) Neglects Other Sources of Savings:
The pro-pounders of this theory include savings out of current income in the supply schedule of savings which makes it inadequate. Considering the supply of capital to be inters elastic, people might lend their past savings with the rise in the rate of interest and so increase the supply of capital.
Similarly, bank credit is an important source of the supply of capital. Banks lend more during periods of slow business activity. The classical theory remains incomplete when it neglects these factors in the supply schedule of capital.
(6) Unrealistic Assumption of Full Employment:
The classical theory is based on the unrealistic assumption of full employment. In a fully employed economy interest as a reward for saving waiting or abstinence is necessary to induce people to save. But according to Keynes, underemployment and not full employment is the rule and where resources are unemployed, interest is not essentially an inducement to savings.
(7) Neglects Monetary Factors:
The classical theory is a pure or real theory of interest which takes into consideration the real factors like the time preference and the marginal productivity of capital. It completely neglects the influence of monetary factors on the determination of the rate of interest.
The classical economists regarded money as a veil, a medium of exchange over goods and services. They failed to consider it as a store of value. Keynes, on the other hand, laid emphasis on explaining the determination of the rate of interest as a monetary phenomenon.
(8) No Automatic Equality between Equilibrium and Market Rates of Interest:
According to the classical view, the market and the equilibrium (natural) rates of interest are always equal. Any discrepancy between the two is only a temporary phenomenon which would disappear in the long run. Keynes, however, does not regard the discrepancy between the two as accidental and temporary.
It can be due to the contraction or expansion of bank credit. An expansion of bank credit by increasing the supply of loanable funds brings about a fall in the market rate of interest below the equilibrium rate and vice versa. Thus there is no automatic mechanism for the equality of the market and equilibrium interest rate.
(9) Difference over the Definition of Interest:
Keynes differs with the classical economists even over the definition and determination of the rate of interest. According to him, it is the reward of not hoarding but the reward of parting with liquidity for a specified period. It is the ‘price’ which equilibrates demand for money with the available quantity of money.
He does not agree that it is determined by the demand for and supply of capital. Thus, Keynes dismisses the classical theory of interest as absolutely wrong and inadequate.