The Classical theory of interest defines the rate of interest as the element that equates savings and investment. Here investment is nothing but the demand for investible resources and savings is their supply. The rate of interest that is determined by the interaction of investment and savings is the price of the investible resources. Proponents of the classical theory of interest have different ways of looking at the theory and they may be explained as under:
Marshall: According to Marshall the interest rate is the price paid for the use of capital. This rate of interest is determined by the equilibrium formed by the interaction of the aggregate demand for capital; and its forthcoming supply.
Taussig: According to Taussig, the interest rate is determined at the level where the marginal productivity of capital equals the marginal instalment of saving.
John Maynard Keynes: According to Keynes the interest rate definitely influences the marginal propensity to save. This savings is also linked to the level of income. Hence it is concluded by Keynes that the rate of interest should be at a point where the demand curve for capital at different interest rates intersects the savings curve at a fixed income level.
Criticism of the Classical Theory of Interest
The fact that the demand for capital , the effect of interest on savings out of a fixed income level are all given, there should be a strong correlation between the interest rate and the income level.
If the interest rate, the demand for capital and the sensitivity of the marginal propensity to save to a change in the interest rate are all given then the income level would be the factor that would equate savings with investment.
Again according to the classical theory, if the demand curve for capital shifts or both shift, then the new equilibrium rate of interest would be determined at the new point of intersection. This concept is criticised to be totally wrong since the constancy of income does not tally with the notion that the two curves shift independent of each other. The shift of either of the two curves would change the income level and hence the entire assumption of fixed income level breaks down.
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Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. IMF’s Chief Economist from September 2003 to January 2007. Inaugural recipient of the Fischer Black Prize.
Professor of Economics & Director of the Earth Institute at Columbia University. Special Adviser to the UN Secretary-General on the Millennium Development Goals. Founder & co-President of the Millennium Promise Alliance.
Chancellor of the Exchequer of the United Kingdom from 1992 to 2007. Prime Minister of the UK between 2007 and 2010. Inaugural 'Distinguished Leader in Residence' at New York University. Advisor at World Economic Forum
Mario I. Blejer is a former governor of the Central Bank of Argentina and former Director of the Center for Central Banking Studies at the Bank of England. Eduardo Levy Yeyati is Professor of Economics at Universidad Torcuato Di Tella and Senior Fellow at The Brookings Institution.
James W. Harpel Professor of Capital Formation and Growth at the John F. Kennedy School of Government in Harvard University. Director of Program in International Finance and Macroeconomics at the National Bureau of Economic Research.