Classical theory and Keynes theory:

Having looked at the basic theory of interest determination in a microeconomic saving-consumption theory, let us look at some other theories put forward to explain the  levels of interest rates prevailing in an economy. We look at three basic theories: the classical theory, Keynes's theory and the loanable funds theory. Let us start with Classical theory first.

The Classical theory is associated with Ricardo and Hume. Also, the basic neoclassical-type theory of the kind presented above was put forward by Irving Fisher and this too comes under Classical theory. For the Classical economists in the 18th, 19th  and early 20th  century, interest rates are a real phenomenon in the sense that the interest rate is determined by real factors. Monetary processes and factors do not into play at all in the determination of interest rate levels. It is merely the supply of saving and the demand for investment  that determines the equilibrium rate of interest.  Saving may be done by individuals, households, business firms, or the government. Saving is the excess of income over consumption, and given the level of income, there is a particular level of saving determined.  Given the income, consumers and firms have a natural tendency to spend that income on current consumption, that is consumption now rather than later. There is a time preference for the present, as you just studied in the previous section (on time value of money- of course, the Classical economists were primarily  speaking of real consumption of goods rather than money). Thus for consumers and firms, according too Classical theory, money now is valued more than money next year. Because of time preference or 'impatience', as Fisher put it, deferred consumption involves a 'sacrifice'. To induce these economic agents to make this sacrifice, they must be offered a reward. This reward is called the 'rate of interest'. Hence, interest is a reward for sacrifice, or abstinence, or 'waiting'. On the side of investment, that is, on the demand side, firms demand capital goods for to make profits by producing goods. Investment takes place because investing in more roundabout or indirect methods or process of production. The scope to produce more efficiently using roundabout methods of production determines investment demand. The saving as a function of the interest rate is an upward sloping curve, while investment as a function of interest rate is a downward sloping line. The intersection of the saving and investment curves gives the equilibrium rate of interest and the equilibrium amount of saving and investment in the economy. The interest rate so determined is called the 'natural' rate of  interest.

In a static situation, that is, at a point of time, this interest rate is not affected by monetary phenomena. Also, according to the  classical theory, interest rates are not much affected by the actions and behaviour of banks and other credit institutions. The Classical theory has certain shortcomings. The theory does not consider several dimensions of a modern economy like business fluctuations, and even financial markets! It is also restrictive because it assumes perfect competition and price flexibility. There may be many other factors in a modern economy that might affect the flow of funds and the interest rate. Now we turn to the Lonable Funds theory. This theory of interest rate determination is in some sense similar in spirit to the Classical Theory but  makes certain modifications to it. Basically, it suggests that a combination of real and monetary factors determine the interest rates. It suggests modifications to two basic points which the classical theory holds. The Classical theory suggested first, that  although interest is paid in monetary terms on money loans and assets, the level of interest is not related to the level of money and prices. Secondly, the Classical theory holds that banks and other intermediaries merely channel savings to investors; they  cannot influence the level of interest.   It is these two propositions that the loanable funds joins issue with. The loanable funds theory discards the independence of the interest rates from the behaviour of money and banking. According to the loanable funds theory, to the real forces determining interest rates should be added a monetary component of saving associated with the creation of new money and credit. The supply of credit has a monetary component. This approach also gives banks and credit  agencies some role in increasing the flow of loanable funds and thus putting downward pressure on the interest rates. The rate of interest clears the supply of saving plus credit.

We finally come to a discussion of the Keynesian theory of interest. The classical theory took one extreme position in assigning no role to monetary phenomena in the determination of interest rates and suggesting that interest rates are determined only by real forces. The Keynesian theory takes a completely opposite view: according to Keynes, interest is primarily a monetary phenomenon. The rate of interest is determined by the money supply and hence on monetary policy indirectly, and on the demand side it is influenced by the attitude of people towards holding of cash balances, and also on the motive for which such balances are held. In the Keynesian approach, interest is not the reward for time waiting or abstinence. It is the reward for inducing people to hold securities instead of cash. Interest is the difference between yield on safe cash and risky securities; it emerges as a price of inducing people to give up liquidity of holding money in favour of holding securities. The demand for holding money is called liquidity preference. You have read about the Keynesian theory of demand for money in the course MEC-002 on macroeconomics. There you read that there are three motives for holding money: the transactions motive, the precautionary motive and the speculative motive. It is the last motive, together with the role of expectations about future interest rates, which determines the interest rates, of course, with the money supply, too, playing a  role. However, money supply is itself exogenous and under control of the monetary authorities. The demand for, and supply of, money determines the equilibrium interest rate. Increases in the supply of money or reduction in the demand for money lowers the interest rate.