( CLASSICAL THEORY)
Meaning of Interest rate:
 What is interest rate?
 It is the rate of return on capital. In other words,
interest is the price paid for borrowed funds. It is cost
to the borrower and return to the lender.
 Two types of interest rate – nominal and real.
 Nominal interest rate – the rate at which funds can
be borrowed from the market.
 Real interest rate – It is the nominal rate of interest
corrected for inflation. Or
 Real interest rate = Nominal interest rate – inflation
rate.
Three school of thoughts for the
theory of interest:
 1. Classical (Economists like, J.B. Clark, F.H. Knight,
Fisher, Bohm-Bawerk, N. Senior, and others):
According to this school interest rate (r ) is determined
by Saving (S) and Investment (I).
 2. Neo-classical (Economists such as Wicksell, Ohlin,
Haberler, Robertson, Viner, and others): It is also
known as Loanable Funds Theory of interest.
According to this school monetary and non-monetary
both forces plays role in the determination of interest
rate.
Contd…
Continued…
 3. Keynes’ Theory of the rate of interest: This theory is
also known as Liquidity Preference Theory. According
to Keynes the liquidity preference and the supply of
money determine the rate of interest.
Details of the Classical Theory of
Interest
Assumptions:
Generally there is full employment situation.
2. Households are the net savers and Producers are the
net borrowers.
3. No government intervention.
1.
Definitions of interest rate
 According to Fisher: An interest rate is the price a
borrower pays for the use of money they borrow from a
lender.
 Nasau Senior: The interest is compensation for the
sacrifice of abstaining from consumption. Interest
arises because of the abstinence involved in the act of
saving.
 Marshall: interest is the price for postponing
consumption.
Determination of the Rate of
Interest: Classical Approach
 According to the Classical theory, rate of interest is
determined by the supply of savings and demand for it
to invest.
 Higher the rate of interest, higher the savings by the
households. More savings means increasing rate of
sacrifice, so to compensate it higher interest rate as
reward. A simple saving equation is below: S = f ( r ),
where S is saving and r is interest rate. Contd…
Continued…
 Lower the rate of interest, higher the demand for
investment by the producers. As investment increases
the M.E.C decreases, therefore investment demand
rises when interest rate falls. The equation for
investment is: I = f ( r ), where I is investment.
 The rate of interest is determined by the equality of S
and I equations.
Figure-1: Equilibrium rate of interest at the
intersection of S and I curves.
Explanation of Figure-1
 X-axis represents S&I, whereas Y-axis represent r.
Supply of saving curve and demand for investment
curve are represented by S and I respectively.
Equilibrium rate of interest is at the intersection of
above two curves. At equilibrium the S=I and r* is the
interest rate.
Limitations of the Classical Theory:
 1) Full employment situation is impractical.
 2)Income effect on saving has been ignored.
 3) The effect on consumption due to higher saving is
not considered.
 4) The Classical theory is indeterminate.