Classical theory of

interest
Chanima B.
 Meaning
It’s a payment for use of capital goods
and induces people to save

According to;
1. loanable fund theory – price paid for
use of loanable funds

2. liquidity preference theory – price for

surrendering liquidity preference
A)Net interest
B)Gross Interest
1)Net interest
2)Insurance against risk
3)Wages of management
4)Return for inconvenience
Theories of interest
Abstinence theory-Senior
Said savings involves abstinence or sacrifice

Waiting theory – Marshall

Savings implies waiting

The pure theory of Interest

J.B.Clark model:-
 Assumptions of J B Clark’s model
Perfect competition n knowledge of future
Involves no entrepreneur, no risk bearing to
be compensated, no profits no investment
Borrowing is for productive purposes only
Supply of monetary saving is given
constant amount
 OM=given amount of savings available
IN=rate of interest and opportunity cost of using capital
MfC=marginal factor cost or opportunity cost of using
capital
MrP=marginal revenue product of the firm
OE=the firm’s determined employment of capital
Firm will use K to the point that its MvP=opportunity cost

Marshallian model :-
Here supply of free capital is not constant
Demand schedule- expected marginal product
of real capital
Supply schedule-real cost of saving free
capital
determines r.o.i. and vol. of real investment
S-S’=supply function of free capital
D-D’=MvP
OM=equilibrium employment of capital
OI=rateof interest
IN(MfC)=marginal factor cost n
opportunity cost
MrP=expected n discounted MrP
OE=equilibrium employment of K by
firm
OI=rate of interest

• Austrian theory of Interest

• John rae in 1834 final shape by Bohm bawerk
• Interest arises because people prefer present goods to
future goods
• It’s a discount,use to induce people to lend money
• Bohm bewark’s THREE reasons
1)prospective underestimate of future
2)present wants are felt more keenly than future wants
3)present goods posses “a technical superiority over
future goods”

Fisher’s Time Preference Theory

Unlike the bohm bawerk’s thought future is as certain as
present
Impatient to spend their income now(depends upon):-
 1)size of income
 2)distribution of income
 3)degree of certainty regarding enjoyment in future
 4)character of individual
Wicksell’s Theory
 talked about “Money rate” and “Natural rate”
 Money rate - r.o.i actually prevailing in loan market
 Natural rate - r.o.i what investor’s think it should be
 Equilibrium exists only when these 2 forces are equal

• Determination of rate of Interest

 Classical economists believe rate of interest is
determined exclusively by real forces
 Savings - in deciding b/w present
gratification(consumption)and future
gratification(saving) individual is concerned with
opportunity cost of each alternative
Investment:-
• level of investment demand schedule
depends on stock of K(MEC)
• MEC is downward sloping to the right
• Net investment rate moves existing K-stock
to new optimum level
• Yield of Net investment >= market r.o.i
• As rate of investment rose MEI (expected
yield on investment) falls