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Theories Of Interest Rate

 Theories of Interest Rate


In this chapter we are going to discuss the significant theories of interest rates. The Classical Theory of Interest Rate and the Keynesian Liquidity Preference Theory of Interest Rates are widely applied.

The Classical Theory Of Interest Rate

As the classical thesis, rate of interest is ascertained by the supply of and demand for capital. The supply of capital is administered by the time preference and output of capital is based on savings, waiting or thrift. The theory is hence, also known as the supply and demand thesis of savings.

  • Demand Side

    • The demand side of capital consist of the demand for efficiency and consumptive causes. Devoid of the latter cause, capital is demanded for the reason that it is efficient.

    • However the efficiency of capital is subject to the law of variable rations. Extra units of capital are not as efficient as the earlier units.

    • A phase comes, when the application of an extra unit of capital in the business is just worth while and no more. Presume a depositor deposits hundred thousand dollars in a factory and anticipates capitulate of 25%. Another instalment of an equal amount would be as efficient as the first one might fetch him 20%.

    • Whilst, a third instalment might capitulate him 15%. If he has borrowed the money at 15%, he will not get into the contract to deposit more. For the rate of interest is merely equal to the marginal efficiency of capital to him.

    • It represents that at a higher rate of interest, the demand for capital is less and it is huge at a lesser rate of interest. Therefore, the demand for capital is contrariwise associated to the rate of interest and the demand schedule for capital or investment curve inclines downwards from left to right.

    • There are nevertheless, definite aspects which administer the demand for capital such as the development of population, technical progress, procedure of rationalisation, the standard of living of the society etc.  

  • Supply Side

    • The supply of capital is based on the savings, somewhat upon the determination to save and the power to save of the society. Few people thrift not bothering the rate of interest.

    • They would proceed to save even if the rate of interest is just enough to persuade them to thrift. They would diminish their savings if the rate of interest drops below this level.

    • Still there are the probable thriftier who would be persuaded to save if the interest rate were mounted.

    • To the last two sorts of savers, saving comprises a sacrifice, abstinence or waiting when they forgo present consumption with regards to earn interest.

    • The huger the rate of interest, the huger will be the society’s savings and the more will be the supply of funds. The supply curve of capital or the saving curve thus shifts upward to the right.

  • Ascertainment

    Presuming the level of earnings to be specified, the rate of interest is ascertained by the interaction of the demand curve and the supply curve of saving. This is presented in the diagram 1 where I and S curves intersect at E which is in the symmetry point when OQ volume of capital is demanded and supplied at R rate of interest.

    If at any phase the rate of interest enhances above R, the demand for investment will enhance. As the supply of savings is more than the demand (R1s > R1d), the rate of interest will come down to the symmetry level OR. The conflicting will be the crate if the rate of interest drops to R2.

    The demand for investment funds is huger than the supply savings (R2d1 > R2S1) rate of interest will enhance to R. the final circumstance is one of the parity amidst saving and investment brought about by the symmetry or the normal rate of interest.


    If at any point of phase people become frugal and save larger than OQ, the rate of interest would drop by the downward shift of the saving of the saving curve to S1, where it overlaps the curve I at d1 and the rate of interest drops to R2. At the lesser rate of interest people will thrift few however the demand for investment money will enhance which will lead in increasing the rate of interest to the symmetry level R.


The unadulterated or the genuine thesis of interest of the classical, as articulated by Marshall and Pigou has been numerously criticised by Keynes.

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