The Classical Theory of Rate of Interest, also known as the Saving-Investment Theory, explains the determination of interest through real forces of the economy. According to classical economists like Marshall and Pigou, interest is the reward for saving or abstinence and is determined by the interaction of savings and investment. The theory considers interest as a real phenomenon and ignores monetary influences.
Rate of interest is the price paid for the use of capital. It is generally expressed as a percentage of the principal amount. It acts as a reward for postponing present consumption and encourages savings in the economy.
According to the classical theory, the rate of interest is determined by the equality between savings and investment. Savings represent the supply of capital, while investment represents the demand for capital.
Supply of Capital (Savings): Savings increase with an increase in the rate of interest because individuals are encouraged to postpone their present consumption in order to earn higher returns in the future. Thus, a higher rate of interest motivates people to save more, resulting in an upward sloping savings curve.
Demand for Capital (Investment): Investment depends on the profitability of investment projects. When the rate of interest is high, borrowing becomes costly and fewer investment projects remain profitable. Therefore, investment decreases. Conversely, when the rate of interest is low, borrowing becomes cheaper and investment increases. Hence, the investment curve slopes downward.
The equilibrium rate of interest is determined at the point where the saving curve intersects the investment curve. At this point, savings are exactly equal to investment (S = I), and there is no excess demand or supply of capital in the economy.
If the rate of interest is above equilibrium, savings will exceed investment, leading to a fall in the interest rate. Similarly, if the rate of interest is below equilibrium, investment will exceed savings, causing the interest rate to rise. Thus, the rate of interest automatically adjusts to bring equilibrium in the capital market.
Equilibrium is determined at point E where Savings = Investment
The classical theory provides a simple and logical explanation of interest determination through savings and investment. However, due to unrealistic assumptions and neglect of monetary factors, it is considered incomplete. Later theories like Keynesian theory provided a more realistic explanation.