The Classical Theory of Interest (The Saving-Investment Theory of Interest)

The Classical Theory of Interest:

This theory is also known as the demand and supply theory of interest. It was propounded by the old, classical economists and has been developed and refined by economists like Marshall, Pigou, Cassels, Walras, Taussig, and Knight.

According to this theory, the rate of interest is determined by the demand and supply of capital. The rate of interest settles at the point where the demand for capital is equal to the supply of capital. Since the demand for capital arises from investments and the supply of capital springs from savings, we can say that the rate of interest is determined, in reality, by savings and investments. To be more accurate, the rate of interest is determined, under conditions of perfect competition, by the intersection of the investment-demand schedule and the saving schedule. The rate of interest is constructed to be the balancing factor which equates the volume of saving with the volume of investment.

It should be noted that the classical theory refers to saving as real saving and to investment as real investment. Real saving refers to those goods which instead of being consumed are employed for productive purposes. Real investment refers to the actual production of a new piece of capital- a machine, a workshop, a factory, etc., as distinct from monetary investment, such as stocks and shares. It is on account of this fact that the classical theory is referred to as the real, non-monetary theory of interest.

We shall now analyze the two sides of the problem of interest determination, namely, the demand for capital (investment schedule) and the supply of capital (supply schedule).

Demand for Capital (Investment Schedule):

The demand for capital rises on account of its productivity. But capital is not equally productive in all its uses. In some uses, it is more productive than in others. Since the supply of capital is scarce in relation to its demand, it is always employed in those uses where its return is comparatively high. If, however, its supply increases, it is put to less productive use. This means that the marginal productivity of capital diminishes as more and more of it is used for production. This is in conformity with the law of diminishing returns. The marginal productivity curve of capital of a firm slopes downwards from the left to the right. An individual firm will decide the amount of capital to be employed by comparing the market rate of interest with the marginal productivity of capital. It will use that amount of capital where the marginal productivity of capital equals the market rate of interest. Remember that for an individual firm, the market rate of interest is given. It has to adjust itself to that market rate of interest with the help of the curve of the marginal productivity of capital. If the market rate of interest rises, the firm will use less capital so as to equate the marginal productivity of capital with the market rate of interest at a higher level. On the contrary, if the market rate of interest falls, the firm will use more capital so as to equate the marginal productivity of capital with the market rate of interest at the lower level. The demand curve of the capital of the firm, therefore, slopes downwards to the right. This will be true not only of the firm or industry but of the community as a whole. The lower the rate of interest, the greater shall be the demand for capital. The aggregate demand curve for capital (or, investment) will, therefore, slope downwards to the right, as shown in the diagram below (the II curve is the aggregate investment curve).

Supply of Capital (Saving Schedule):

The supply of saving in a community is determined by several factors, such as the level of income, standard of living, family affection, far-sightedness, peaceful political conditions, etc. If we assume all these conditions to remain constant, then the most powerful factor which influences the supply of savings at any particular time is the rate of interest. The higher the rate of interest, the higher shall be the volume of savings, and vice-versa. This, however, applies to the normal savers. But there are people who do not pay much attention to the rate of interest and continue to save as usual even if the rate of interest falls. This applies particularly to those people who wish to have a fixed income in the future. It should, however, be remembered that the rate of interest exerts an important influence on the savings of ordinary people. Ordinarily, the higher the rate of interest, the greater the saving of the people. That is the reason why the supply curve of capital rises upward from the left to the right. The aggregate supply curve of capital (or, saving) is shown in the diagram below in the form of the SS curve. According to the classical theory, the rate of interest, on the supply side, must be high enough to induce the marginal saver to save, falling which the marginal saver shall decline to save, the total supply of capital shall fall short of the total demand for capital, and ultimately the rate of interest shall rise high enough to compensate the marginal saver.

Equality of Saving and Investment:

The rate of interest, as pointed out above, is determined by the equality of saving and investment. It settles at that point where the aggregate demand for capital is equal to the aggregate supply of capital. Saving and investment are equal at this equilibrium point.

The classical theory of interest can be illustrated with the diagram given below.

PM (or, Oq) represents the equilibrium rate of interest in this diagram. It is the result of the equilibrium between the demand and supply of capital under conditions of perfect competition. Oq’ cannot be the equilibrium rate of interest because at this rate the supply of capital q’S’ exceeds the demand for capital q’d. Likewise, Oq” cannot be the equilibrium rate of interest because at this rate of interest the demand for capital q”S” exceeds the supply of capital q”d”.