The Classical Theory of Interest or Real Theory of Interest seeks to explain the determination of rate of interest by real factors like productivity and thrift i.e. productivity of capital goods and saving of goods. According to this theory the rate of interest is payment for savings. The rate of interest in this theory is determined by demand for savings to invest in capital goods and the supply of savings. Let us explain there demand and supply side.
Demand for Savings:
The demand for capital goods comes from firms which desire to invest, that are to purchase or to make new capital goods. Capital goods are demanded because they have a revenue productivity like all other factors. For any given type of capital assets e.g. a machine, it is possible to draw marginal revenue productivity curve showing the addition made to the total revenue by additional unit of machine at various levels of stock of that machine. We have said that capital like other factors of production has marginal revenue productivity. But marginal revenue productivity of capital is more complex concept than that of other factors, because capital has a lie of many years.
A capital asset continues to yield returns for many years. Therefore the entrepreneurs have to take into consideration the uncertainties of the future and estimate the percentage yield or returns from capital after making allowance for maintaining and operating costs. In other words they have to find out the net expected return of the marginal unit of capital expressed as percentage of the cost of the capital assets. The more capital assets of given kind of entrepreneur has the less revenue or income he will expect to earn by purchasing one more machine of the same kind. Therefore the marginal revenue productivity curve of capital slopes down ward towards the right. Now under perfect competition, it is profitable for a firm to purchase any factor up to the point at which the price of that factor equals to its marginal revenue productivity. The price of the savings required to purchase the capital goods is obviously the rate of interest. Hence the entrepreneur will demand capital goods or will demand savings to purchase capital goods up to the point at which the expected net rate of return on the capital goods equals the rate of interest. Since the marginal revenue productivity curve of capital goods slopes down words, it follows that as the rate of interest falls, more capital goods will be demanded and also more money will be required to purchase these capital goods.
Here MRP is the marginal revenue. On the Y-axis net rate of return on capital and rate of interest are shown, while X-axis represents the amount of capital. At or rate of interest, OM amount of capital is demanded. This is so because only at OM amount of capital the falling net rate of return on capital becomes equal to prevailing rate of interest Or. Now if the rate of interest fall, from Or to Or', then the amount of capital demanded will increase from OM to OM', the falling net rate of return equal to the new interest rate Or'.
Thus it is clear that marginal revenue productivity curve of capital shows the demand for capital and further that the demand for capital or demand for savings to buy the capital, the capital slopes downwards to the right. This is true for individual industries and for the community as a whole.
Thus we conclude that demand for individual capital goods and for capital goods in general will increase at the rate of interest falls.
Supply of Savings
According to this theory, the money which is to be used for purchasing capital goods is made available by those who save from their current income. By postponing consumption of a part of their current incomes, they release resources for productive purpose. Saving involve the element of waiting for the future enjoyment of saving. But people prefer the present enjoyment of goods and services to the future enjoyment of then. Therefore if people are to be persuaded to save money and to lend it to entrepreneurs they must be offered some interest as reward. More savings the people will do, the more consumption they will have to postpone, the higher must be rate of interest they will to make such postponement worth while. Thus to induce people to save higher rates of interest must be offered. Moreover higher rates of interest have also to be paid if savings have to come from those persons whose rate of time preference are relatively more strongly in favour of present satisfaction. The supply curve of capital will therefore slope upward to the right.
Equilibrium between Demand and Supply
The rate of interest is determined by the interaction of the forces of demand for capital or investment and the supply of savings. The rate of interest at which the demand for capital or demand for savings to invest capital goods and the supply of savings are in equilibrium will be determined in the market.
Here SS is the supply curve of savings and II is the demand curve of savings to invest in capital goods (II is also called curve for investment). The demand for investment and supply of savings are in equilibrium at Or rate of interest, where the curve intersect each other. Hence Or is the equilibrium rate of interest, which will come to stay in the market. In this equilibrium position OM amount of capital is lent, borrowed and invested. If any change in the demand for investment tend to supply of savings come about, the curve will shift accordingly, and therefore the equilibrium rate of interest will also change.
Criticism
The Classical Theory of Interest came in for serious criticism at the hands of Keynes.
i) It is pointed out that Classical Theory of Interest is based upon assumption of full employment of resources. In other words it assumes that an increase in production of one thing must mean the withdrawal of some resources from the production of other things. With in the framework of the system of the theory built on the assumption of full employment, the notion of interest as a reward for waiting or abstinence is highly plausible. It is the premise that resources are typically fully employed that lacks plausibility in the contemporary world. If at any time in the country, unemployed resources are found on large scale to wait in order that more resources should be devoid to the production of capital goods.
ii) According to Classical theory of Interest, more investment can take place only by curtailing consumption. Greater the reduction of consumption more is the saving and therefore more investment. But a decrease in the demand of consumer goods is likely to lessen the incentive to produce capital goods and therefore will affect investment adversely.
iii) By assuming full employment, the Classical Theory has neglected changes in the income level. By neglecting the change sin the income level, the Classical theory is led into error of viewing the rate of interest as the factor which brings quality between savings and investment is brought about not by changes in the rate of interest but by changes in the level of income.
iv) According to Classical Theory the investment demand schedule can change or shift without causing a change or shift in saving curve schedule. For example according to Classical Theory, if investment demand schedule or curve shifts downwards, then the new equilibrium rate of interest will be determined. Where this new investment demand curve cuts the old saving curve which has remained unchanged. But this is wrong. As we know from Keynesian Economics, fall in investment leads to decrease in income and out of the reduced income, less is saved and therefore savings curve also changes. Thus we see that Classical Theory ignores the effect of changes in investment on savings.
v) Classical Theory as pointed out by Keynes is indeterminate. Position of the savings schedule or curve depends upon the income level, which is the position of savings curve or schedule will very with the level of incomes. There will be different savings schedules for different levels of incomes. As income rises for example the savings scheduled or curve will shift to the right. Thus we can not know what the rate of interest will be unless we already know the income level without already knowing the rate of interest, since a lower rate of interest will mean a large volume of investment and so via the multiple, a higher level of real income.
The Classical Theory therefore offers no solution and is determinate.
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