Interest rates represent one of the most critical prices in any economy, influencing decisions related to consumption, saving, investment, and capital allocation. They serve as the cost of borrowing and the return on lending, playing a pivotal role in the allocation of scarce resources over time. The determination of the interest rate has been a subject of extensive debate among economists, with two prominent schools of thought offering distinct perspectives: the Classical theory and the Keynesian theory. While the Classical economists viewed the interest rate primarily as a real phenomenon determined by the forces of saving and investment, Keynes challenged this perspective, arguing that it is fundamentally a monetary phenomenon influenced by the supply and demand for money.

These differing views not only reflect contrasting theoretical frameworks but also lead to vastly different policy prescriptions. Understanding the nuances of both the Classical and Keynesian theories of interest is essential for grasping the evolution of macroeconomic thought and for appreciating the complex interplay of real and monetary factors in financial markets. This discussion will delve deep into the assumptions, mechanisms, determinants, and implications of each theory, providing a comprehensive analysis of their respective contributions to economic understanding.

Classical Theory of Interest

The Classical theory of interest, deeply rooted in the pre-Keynesian era of economic thought, primarily views the interest rate as a “real” phenomenon determined by real factors in the economy. It is essentially a price that equilibrates the supply of loanable funds (savings) with the demand for loanable funds (investment). In this framework, the interest rate is seen as a reward for “abstinence” or “waiting” (saving) and a cost for “productivity” or “investment.”

Core Assumptions

The Classical theory is built upon several foundational assumptions that shape its conclusions:

  1. Full Employment: The economy is assumed to operate at or near full employment of its resources. Any deviations are temporary and quickly corrected by flexible wages and prices. This implies that the aggregate supply of output is fixed at the full employment level.
  2. Flexibility of Prices and Wages: Prices and wages are perfectly flexible and adjust quickly to clear markets, including the labor market and the goods market. This ensures that the economy automatically gravitates towards full employment.
  3. Real Factors as Determinants: The interest rate is determined by real factors of productivity and thrift. Productivity influences the demand for investment, while thrift (saving) determines the supply of loanable funds. Money is considered a “veil,” meaning it only affects the nominal price level and does not influence real variables like output, employment, or the real interest rate. This concept is often referred to as the “neutrality of money.”
  4. Loanable Funds Market: The interest rate is determined in the market for loanable funds, where funds are borrowed and lent. These funds primarily come from savings and are used for investment.

Supply of Loanable Funds (Savings)

According to the Classical theory, the supply of loanable funds primarily originates from savings. Savings represent the portion of income that is not consumed. The primary motivation for saving is often seen as the desire to earn interest, which compensates individuals for postponing current consumption.

  1. Positive Relationship with Interest Rate: The Classical economists posited a positive relationship between the interest rate and the level of saving. A higher interest rate provides a greater incentive for individuals and firms to save, as it means a higher return on their deferred consumption. Conversely, a lower interest rate would reduce the incentive to save.
  2. Sources of Savings:
    • Household Savings: Households save for future consumption, retirement, or bequests. The level of household saving is sensitive to the interest rate.
    • Business Savings: Firms retain a portion of their profits for future expansion or to build up reserves. These retained earnings can also be influenced by the prevailing interest rate.
    • Government Savings: A budget surplus (government revenue exceeding expenditure) represents government saving, which adds to the supply of loanable funds. A budget deficit, conversely, represents government dissaving, which reduces the supply of loanable funds.
  3. Other Determinants: While the interest rate is the primary determinant, other factors like income levels, time preference (how much people prefer present consumption over future consumption), and wealth distribution can also influence the aggregate supply of savings. However, the interest rate is seen as the most direct and responsive factor.

Demand for Loanable Funds (Investment)

The demand for loanable funds primarily comes from businesses seeking to undertake investment projects. Investment, in this context, refers to the creation of new capital goods (e.g., factories, machinery, infrastructure).

  1. Negative Relationship with Interest Rate: The Classical theory asserts a negative relationship between the interest rate and the level of investment. Firms undertake investment projects when the expected rate of return from the project (known as the Marginal Efficiency of Capital or MEC) is greater than or equal to the cost of borrowing (the interest rate). A higher interest rate increases the cost of borrowing, making fewer projects profitable and thus reducing the demand for investment funds. Conversely, a lower interest rate makes more projects financially viable, increasing the demand for loanable funds.
  2. Determinants of Investment:
    • Marginal Efficiency of Capital (MEC): This refers to the expected rate of return on an additional unit of capital. Factors like technological advancements, expected future demand for goods, and innovation can increase the MEC, shifting the investment demand curve to the right.
    • Business Expectations: Optimistic business expectations about future economic conditions can spur greater investment.
    • Existing Capital Stock: If the existing capital stock is fully utilized or insufficient, there will be a greater incentive for new investment.

Equilibrium in the Loanable Funds Market

The equilibrium real interest rate in the Classical framework is determined at the intersection of the aggregate supply of loanable funds (savings) and the aggregate demand for loanable funds (investment). At this equilibrium interest rate, the amount that savers are willing to lend is exactly equal to the amount that investors are willing to borrow.

  • If the interest rate is above the equilibrium level, there will be an excess supply of loanable funds (savings greater than investment demand). This surplus will put downward pressure on the interest rate, encouraging more investment and discouraging saving until equilibrium is restored.
  • If the interest rate is below the equilibrium level, there will be an excess demand for loanable funds (investment demand greater than savings). This shortage will push the interest rate upwards, encouraging more saving and discouraging investment until equilibrium is reached.

This mechanism ensures that the market for loanable funds clears, and the real interest rate adjusts to balance the desire to save with the desire to invest.

Role of Money in Classical Theory

In the Classical view, money’s primary function is as a medium of exchange. The quantity theory of money (MV=PT) dictates that the supply of money primarily determines the general price level, not the real interest rate. Changes in the money supply are seen as having no long-term effect on real variables like investment, saving, or the real interest rate. Money is considered a “neutral” veil over the real economy. This perspective implies that monetary policy can only influence nominal variables, such as the price level, but not real economic activity or the real rate of interest.

Policy Implications

Given its assumptions, the Classical theory suggests that:

  • Fiscal Policy: Government spending or taxation can influence the interest rate. For instance, a budget deficit (government dissaving) would reduce the supply of loanable funds, pushing interest rates up and potentially “crowding out” private investment. A budget surplus, conversely, would increase the supply of loanable funds, lowering interest rates and stimulating investment.
  • Monetary Policy: Monetary Policy is largely ineffective in influencing the real interest rate. An increase in the money supply would only lead to inflation, without affecting the real allocation of resources or the equilibrium interest rate determined by real factors.

Criticisms of Classical Theory

While influential, the Classical theory of interest faces several significant criticisms:

  1. Assumption of Full Employment: The most prominent criticism is its reliance on the assumption of full employment. Historical evidence, particularly the Great Depression, demonstrated that economies can experience prolonged periods of unemployment and underutilization of resources, contradicting this core assumption.
  2. Neglect of Money’s Role: Critics argue that the theory treats money merely as a medium of exchange, neglecting its role as a store of value and its influence on liquidity preferences. It fails to account for the speculative demand for money, which Keynes later emphasized.
  3. Savings and Income: Classical theory overemphasizes the interest rate as the sole determinant of saving. In reality, saving is much more sensitive to income levels. People save more when their incomes are higher, regardless of the interest rate.
  4. Investment and Expectations: While the MEC is acknowledged, the theory might not fully capture the role of animal spirits and business expectations in driving investment decisions, which can be highly volatile and not solely dependent on the interest rate.
  5. Simultaneous Determination: The theory implies that the interest rate is determined independently in the loanable funds market, and then affects investment and saving. However, these variables are interdependent, and changes in one can affect the others in complex ways not fully captured by a simple two-axis diagram.
  6. Real vs. Money Rates: The theory primarily focuses on the real interest rate, but in a monetary economy, decisions are often made based on the nominal interest rate, and the distinction between real and nominal rates and the role of inflation expectations are not fully integrated.

Keynesian Theory of Interest (Liquidity Preference Theory)

John Maynard Keynes, in his seminal work “The General Theory of Employment, Interest, and Money” (1936), offered a revolutionary critique of Classical economics, including its theory of interest. Keynes argued that the interest rate is fundamentally a monetary phenomenon, determined by the interaction of the supply of money and the demand for money (which he termed “liquidity preference”). He defined interest as the reward for parting with liquidity, not the reward for saving.

Core Assumptions

Keynes’s theory operates under different assumptions than the Classical view:

  1. Possibility of Underemployment Equilibrium: Unlike the Classical assumption of full employment, Keynes believed that an economy could settle at an equilibrium level of output and employment below full capacity.
  2. Sticky Prices and Wages: Prices and wages are not perfectly flexible in the short run. This stickiness allows for changes in aggregate demand to impact real output and employment.
  3. Active Role of Money: Money is not neutral; it plays an active and crucial role in determining real economic variables, including the interest rate and the level of aggregate demand.
  4. Interest as a Monetary Phenomenon: The interest rate is determined in the money market, not the loanable funds market. It is the price paid for using money, or the opportunity cost of holding money.

Supply of Money (Ms)

Keynes assumed that the supply of money is exogenously determined by the central bank (monetary authorities). It is largely independent of the interest rate. Thus, the money supply curve is depicted as a vertical line in an interest rate-money quantity plane. The central bank can increase or decrease the money supply through various tools like open market operations, changing reserve requirements, or adjusting the discount rate.

Demand for Money (Liquidity Preference, L)

Keynes posited that individuals and firms demand money not just for transactions but also for other motives. He identified three motives for holding money, collectively forming what he called “liquidity preference”:

  1. Transactions Motive (L1):

    • Purpose: Money is held to bridge the interval between the receipt of income and the disbursement of expenditure. People need cash for everyday transactions (buying groceries, paying bills).
    • Determinants: This demand is primarily a function of the level of income (Y). As income rises, people engage in more transactions and thus need to hold more money. It is largely insensitive to the interest rate.
    • Nature: This component is stable and predictable given the level of income.

  2. Precautionary Motive (L2):

    • Purpose: Money is held to meet unforeseen contingencies or emergencies (e.g., unexpected medical expenses, car repairs, sudden opportunities). It acts as a buffer against uncertainty.
    • Determinants: Like the transactions motive, the precautionary demand for money is also primarily a function of the level of income (Y). Higher income generally allows for larger precautionary balances. It is also largely insensitive to the interest rate.
    • Nature: This component provides a cushion against the unknown.

  3. Speculative Motive (L3):

    • Purpose: This is the most crucial and innovative aspect of Keynes’s theory. Money is held as an asset, in anticipation of profiting from future changes in interest rates and bond prices.
    • Relationship with Interest Rate: There is an inverse relationship between the interest rate and the speculative demand for money.
      • High Interest Rates: When interest rates are high, bond prices are low. Individuals expect interest rates to fall in the future (and bond prices to rise). Therefore, they prefer to hold bonds (or other interest-bearing assets) rather than money, as they can lock in a high return and expect capital gains. The opportunity cost of holding money is high. So, speculative demand for money is low.
      • Low Interest Rates: When interest rates are low, bond prices are high. Individuals expect interest rates to rise in the future (and bond prices to fall), leading to potential capital losses on bonds. In such a scenario, people prefer to hold money, even if it earns no interest, to avoid capital losses and to be in a position to buy bonds when interest rates rise (and prices fall). The opportunity cost of holding money is low. So, speculative demand for money is high.
    • Liquidity Trap: A critical concept associated with the speculative motive is the “liquidity trap.” This occurs at very low interest rates (close to zero). At such rates, individuals believe that interest rates can only rise, and bond prices can only fall. Consequently, the speculative demand for money becomes infinitely elastic; people are willing to hold any amount of money supplied by the central bank, as they prefer liquidity over bonds due to the fear of capital losses. In a liquidity trap, monetary policy becomes ineffective as increases in the money supply simply get absorbed into speculative balances without lowering interest rates further or stimulating investment.

The total demand for money (L) is the sum of these three motives: L = L1(Y) + L2(Y) + L3(r). However, for the determination of the interest rate, the speculative motive (L3) is key, as it is inversely related to the interest rate.

Equilibrium in the Money Market

The equilibrium interest rate in the Keynesian framework is determined by the intersection of the total demand for money (liquidity preference) and the exogenously determined supply of money.

  • If the interest rate is above the equilibrium level, people will be holding less money than they desire at that rate (due to low speculative demand). To acquire more money, they will sell bonds, which drives bond prices down and interest rates up, restoring equilibrium. (Correction: if interest rate is above equilibrium, there is excess supply of money, people hold more money than desired, they will buy bonds, driving bond prices up and interest rates down).
  • If the interest rate is below the equilibrium level, people will be holding more money than they desire at that rate (due to high speculative demand). To reduce their money holdings, they will buy bonds, which drives bond prices up and interest rates down, restoring equilibrium. (Correction: if interest rate is below equilibrium, there is excess demand for money, people want to hold more money, they will sell bonds, driving bond prices down and interest rates up).

Let’s rephrase the equilibrium adjustment for clarity:

  • Excess Supply of Money (Interest Rate above Equilibrium): If the market interest rate is higher than the equilibrium rate, the quantity of money supplied exceeds the quantity demanded. People are holding more money than they desire at that high interest rate (because the opportunity cost of holding money is high, and they prefer to hold bonds). To reduce their excess money balances, they will attempt to buy bonds. This increased demand for bonds drives up bond prices, and since bond prices and interest rates move inversely, the interest rate falls until equilibrium is restored.
  • Excess Demand for Money (Interest Rate below Equilibrium): If the market interest rate is lower than the equilibrium rate, the quantity of money demanded exceeds the quantity supplied. People desire to hold more money at that low interest rate (because the opportunity cost of holding money is low, and they expect interest rates to rise in the future, leading to capital losses on bonds). To acquire more money, they will attempt to sell bonds. This increased supply of bonds drives down bond prices, and consequently, the interest rate rises until equilibrium is restored.

Role of Investment and Saving in Keynesian Theory

Unlike Classical theory, Keynes argued that saving and investment primarily determine the level of income and output, not directly the interest rate. The interest rate, determined in the money market, then influences investment, which in turn affects income. Saving is seen as a residual, determined by income and the propensity to consume, rather than primarily by the interest rate. The equality of saving and investment is brought about by changes in income, not by the interest rate.

Policy Implications

Keynesian theory has significant policy implications:

  1. Monetary Policy Effectiveness: Monetary policy is a powerful tool for influencing the interest rate. An increase in the money supply shifts the money supply curve to the right, lowering the interest rate (assuming not in a liquidity trap), which then stimulates investment and aggregate demand. Conversely, a decrease in the money supply raises interest rates.
  2. Fiscal Policy Influence: Fiscal policy (changes in government spending or taxation) can also indirectly affect the interest rate. For example, an expansionary fiscal policy increases aggregate demand and income. This rise in income increases the transactions and precautionary demand for money, shifting the total money demand curve to the right, which, given a fixed money supply, would lead to a higher interest rate (known as the “crowding out” effect).

Criticisms of Keynesian Theory

Keynes’s theory also faced criticisms:

  1. Purely Monetary Focus: Critics argued that the theory overemphasizes monetary factors and neglects the real forces of productivity and thrift, which certainly play a role in long-run real interest rates.
  2. Exclusion of Saving and Investment: By detaching saving and investment from the direct determination of the interest rate, the theory might appear incomplete. Modern macroeconomic models (like IS-LM) attempt to integrate both real and monetary factors.
  3. The Liquidity Trap: While a powerful concept, the empirical relevance and frequency of the liquidity trap have been debated. While some historical periods (like Japan in the 1990s or post-2008 financial crisis) showed characteristics of a liquidity trap, it is not a universally observed phenomenon.
  4. Determinacy of the Rate: Some critics argued that the theory on its own is indeterminate, as the demand for money depends on income, and income depends on investment, which in turn depends on the interest rate. This circularity suggests the need for a more comprehensive model, which led to the development of the IS-LM framework by Hicks and Hansen.
  5. Exaggeration of Speculative Motive: It is argued that the speculative motive might be less dominant than Keynes suggested, and that other factors, such as inflation expectations or risk aversion, might play a more significant role in determining the demand for money as an asset.

Conclusion

The Classical and Keynesian theories of interest represent two fundamental and contrasting approaches to understanding one of the most vital prices in an economy. The Classical perspective, deeply rooted in the concept of real markets, posits that the interest rate is determined by the interplay of real savings and real investment, reflecting the underlying productivity of capital and the societal preference for present versus future consumption. In this view, money is merely a neutral veil, influencing only nominal prices, and the interest rate acts as a mechanism to ensure that the demand for investable funds aligns with the supply of available savings at full employment.

In stark contrast, Keynes radically shifted the focus, arguing that the interest rate is a purely monetary phenomenon, a reward for parting with liquidity rather than a reward for abstinence. His liquidity preference theory highlights the crucial role of money demand (for transactions, precautionary, and especially speculative motives) and money supply in determining the interest rate. This framework emphasizes the non-neutrality of money and the potential for monetary policy to influence real economic variables, particularly through its impact on the cost of borrowing and the incentive for investment. While the Classical theory emphasizes the supply of loanable funds originating from real saving, the Keynesian theory stresses the demand for money as an asset, influenced significantly by expectations about future interest rates.

Ultimately, neither theory provides a complete picture on its own, and both have contributed significantly to economic thought. Modern macroeconomic analysis often synthesizes elements from both perspectives. The Hicks-Hansen IS-LM model, for instance, integrates the goods market (influenced by investment and saving, reminiscent of Classical real factors) with the money market (where money demand and supply determine interest rates, as in Keynes’s theory) to determine the equilibrium levels of both income and interest rates simultaneously. This synthesis acknowledges that interest rates are influenced by a complex interaction of real factors (like productivity and thrift) and monetary factors (like money supply and liquidity preference). The relevance of each theory often depends on the specific economic context, with Classical insights perhaps more applicable to long-run analysis and full employment scenarios, while Keynesian insights are more pertinent to short-run dynamics, monetary policy effectiveness, and situations of unemployment or liquidity traps.