The classical theory of interest rate states that people want their savings to be loaned for the investment purposes. So, these are the people who supply capital for further investment. whereas in opposition to that, there are some people who need capital in their business. Thus, they borrow the money on behalf of their firms. The people who are in need of capital actually demand the capital. So, both parties exist in the market. The ones who supply capital and the ones who need capital and borrow. The point where the demand for and supply of capital meet, is the point of the interest rate. This classical theory is also known as the real theory of interest because it is based on real forces of demand and supply.
Moreover, the classical theory of interest says that there exists a perfect competition in the capital market. As we have both large numbers of people who supply capital. similarly, there are those who demand capital. So, According to classical theory, the interest rate is determined by the interaction of demand and supply for capital.
Supply of Savings (Capital):
The theory says that supply comes from the households. As we know that people make savings out of their income. they don’t consume all of their income. People save money from their incomes and then use the savings for the investment purposes. So, the supply of capital is the ultimate outcome of savings. The saving depends on the willingness to save, capacity to save and the interest rate.
The capacity to save depends on the level of national and per capita income etc. just because, for the purpose of saving people postpone their current consumption. They want to enjoy the future consumption. Thus, the higher the interest rate, the higher will be the level of saving. Contrary to that, lower the interest rate lower would be the saving. So, there is a direct relationship between interest rate and savings.
Demand for Savings (Capital):
The demand for capital comes from people who have to invest in the business. Whereas, the demand of the capital depends on its marginal productivity. The demand is high for a factor of production when there are high expectations from it. However, with the increased capital and investment, the marginal productivity of the business decreases. This is due to the operation of the law of diminishing returns. The borrower makes a comparison between the interest rate and the marginal productivity of the capital. So, the question arises as how much a person should borrow.
The demand for capital will be up to a level where the marginal productivity of capital becomes equal to the interest paid on it. Thus, when the marginal productivity is greater than the interest paid on it, it is beneficial to borrow capital. Just because the marginal productivity of additional capital employed keeps on diminishing. The borrower attains equilibrium when the marginal productivity of the capital becomes equal to the interest rate paid on it. So, there is an indirect relationship between the interest rate and the demand for capital.
The equilibrium between Demand and Supply:
According to the classical theory of interest in economics, one determines interest rate when the forces of demand (capital) and supply (savings) interact. The point at which demand for capital and supply of capital become in equilibrium is the rate of interest in the market. however, the forces will adjust itself in case of any changes in the supply and demand of capital.Hence, a new equilibrium will be achieved and a new interest rate is determined then.
In this diagram, SS is the supply curve for savings. similarly, II is the demand for the investment curve. E is the point where Supply and demand curve intersects. This is the equilibrium point. by drawing a perpendicular, we come to know that Or is the interest rate. likewise, OM is the amount of money for saving and investment.