The Classical Rate of Interest

Investment is the use of assets (circulating or fixed) to earn profits.

• Interest is the revenue from lending those circulating assets to someone else for them to earn a profit from.
• Interest rate is the rate of revenue in lending.
• Savings are the assets that are taken out of one’s own circulation to be circulated by someone else.

According to the Classical Theory:

• Investment is the demand for investable resources
• Savings represents the supply for investable resources
• The rate of interest is the “price” of investable resources at which the two are equated
• A commodity’s price is fixed where its demand is equal to the supply.

Likewise, the rate of interest rests where the amount of investment at that rate of interest is equal to the amount of saving at that rate. This is found in Marshall’s Principles in a few words.

His theory is:

• Interest is the price paid for the use of capital in any market.
• It tends towards an equilibrium so that the aggregate demand for capital at that rate of interest, is equal to the aggregate stock forthcoming at that rate.[2]

To Professor Cassel’s Nature and Necessity of Interest:

• Investment is the “demand for waiting”
• Savings is the “supply of waiting”
• Interest is a “price” which serves to equate the two

He clearly envisages interest as the factor which brings into equilibrium the marginal disutility of waiting with the marginal productivity of capital.[3]

Sir Alfred Flux writes:

Walras deals with “l’échange d’épargnes contre capitaux neufs” in éléments d’Économie pure. In the Appendix, he argues that each possible rate of interest has:

• a sum which individuals will save and
• a sum which they will invest in new capital assets

He says that:

• these two aggregates tend to equality with one another
• the rate of interest is the variable which brings them to equality; so that the rate of interest is fixed at the point where saving, which represents the supply of new capital, is equal to the demand for it.

Thus he is strictly in the classical tradition.

People brought up on the traditional theory thinks that:

• The interest rate goes down automatically whenever a person saves.
• This then automatically stimulates the output of capital.
• The interest rate falls just enough to stimulate the output of capital to an extent which is equal to the increment of saving.
• This is a self-regulatory process of adjustment. It happens without the necessity for any special intervention of the monetary authority.
• Generally, even today, each additional act of investment raises the interest rate if it is not offset by a change in the readiness to save.

The previous chapters showed that the people’s view is wrong.

Neoclassical Interest

• The Neo-classical school believes that saving and investment can be actually unequal.
• The Classical school believes that they are equal.

Marshall believed that aggregate saving and aggregate investment are necessarily equal.

• The Classical school carried this belief much too far since they held that every act of increased saving by an individual necessarily brings into existence a corresponding act of increased investment.

There is no material difference between my investment demand-curve and the demand curve for capital contemplated by some of the classical writers above.

When we come to the propensity to consume and its corollary the propensity to save, we have a difference of opinion.

This is due to the emphasis which they have placed on the influence of the rate of interest on the propensity to save.

But they would not wish to deny that the level of income also has an important influence on the amount saved.

The interest rate might influence the amount saved out of a given income.

All these points of agreement can be summed up in a proposition which the classical school would accept:

But this is the point at which definite error creeps into the classical theory.

If the classical school merely inferred from the above proposition that, given the demand curve for capital and the influence of changes in the interest rate on the readiness to save out of given incomes, the level of income and the interest rate must be uniquely correlated, there would be nothing to quarrel with.

This proposition leads naturally to an important truth:

The level of income must be the factor that brings the amount saved to equality with the amount invested if the following are given:

• the interest rate
• demand curve for capital
• influence of interest rates on savings from given levels of income

But, in fact, the classical theory neglects the influence of changes in the level of income and involves formal error.

The classical theory assumes that it can then proceed to consider the effect on the interest rate of (e.g.) a shift in the demand curve for capital, without abating or modifying its assumption as to the amount of the given income out of which the savings are to be made.

The independent variables of the classical interest rate are:

• the demand curve for capital and
• the influence of the interest rate on the amount saved out of a given income.

It says that when the demand curve for capital shifts, the new interest rate is the intersection between:

• the new demand curve for capital and
• the curve relating the interest rate to the amounts which will be saved out of the given income.

The Classical theory of interest rates supposes that, if the demand curve for capital shifts or if the curve relating the interest rate to the amounts saved out of a given income shifts or if both these curves shift, the new interest rate will be given by the intersection of the new positions of the 2 curves.

But this is a nonsense theory.

The assumption that income* is constant is inconsistent with the assumption that these 2 curves can shift independently of one another.

If either of them shift, then, in general, income will change. This results in the break down of whole schema based on a given income.

The position could only be saved by some complicated assumption. It would provide for an automatic change in the wage-unit* of an amount just sufficient in its effect on liquidity-preference in order to establish an interest rate which would just offset the supposed shift. This would then leave output at the same level as before.

In fact, there is no hint to be found in the above writers as to the necessity for any such assumption*.

At the best, it would be plausible only in relation to long-period equilibrium. It could not form the basis of a short-period theory. There is no ground for supposing it to hold even in the long-period.