Difference between Classical, Neoclassical, and Keynesian Theories of Interest

This Article will help you to learn about the difference between classical capital theory, the neoclassical loanable funds theory and the Keynesian liquidity preference theory.

Difference between Classical, Neoclassical, and Keynesian Theories of Interest

Difference # Classical Theory:

1. Definition of Interest – According to the classical economists, interest is a reward paid for the use of capital.

2. Nature of Interest – According to the classical economists, interest is a real non-monetary phenomenon and the theory of interest is a real theory of interest.

3. Determination of Rate of Interest – According to the classical theory, rate of interest is determined by the equality between the demand for and supply of capital.

4. Demand Side -In the classical theory of interest, the demand for capital is the demand for investment which is influenced by the marginal productivity of capital. Demand for capital is a negative function of the rate of interest.

5. Supply Side – In the classical theory, the supply of capital comes from saving which depends on the willingness and power to save. The supply of capital is a positive function of the rate of interest.

6. Saving-Investment Equality – According to the classical economists; rate of interest is the equilibrating force between saving and investment.

7. Role of Money – The classical economists considered money as medium of exchange and did not recognise the store-of-value function of money.

8. Minimum Level of Rate of Interest – The classical economists did not believe in any minimum limit to the interest-rate level and accept the possibility of zero rate of interest.

9. Scope of the Theory – The classical theory of the rate of interest has a limited scope because it is based on the assumption of full employment.

10. Relative Importance – The classical theory of interest is a real theory of interest according to which the equilibrium rate of interest is determined by the real factors, i. e., the real saving and real investment. It completely ignores the significant role played by money and bank credit in the determination of the rate of interest. It regards money as neutral, a mere medium of exchange, and does not assign any importance to hoardings.

Difference # Neo-Classical Theory:

1. Definition of Interest – According to the neo-classical economists, interest is a reward for the use of loanable funds.

2. Nature of Interest – According to the neo-classical economists, interest is a real-cum-monetary phenomenon and the theory of interest is a real-cum-monetary theory of interest.

3. Determination of Rate of Interest – According to the neo-classical theory, rate of interest is determined by the equality between the demand for and supply of loanable funds.

4. Demand Side – In the neo-classical theory, the demand for loanable funds is the demand for investment, consumption and hoarding. Demand for loanable fluids for all the three purposes is a negative function of the rate of interest.

5. Supply Side – In the neo-classical theory, the supply of loanable funds comes from savings, dishoarding, bank credit and disinvestment. The supply of loanable funds from all these sources is a positive function of rate of interest.

6. Saving-Investment Equality – According to the neo-classical economists, rate of interest is the equilibrating force between saving and investment.

7. Role of Money – The neo-classical theory took into consideration the importance of monetary factors, like cash, credit, hoardings, etc., while remaining essentially a classical saving- investment theory of interest. It regards money as a flow since the supply of money is related to the period of time. Moreover, the demand for hoarding is not related to the expectations of future rate of interest. Besides, money supply is believed to be interest-elastic in this theory.

8. Minimum Level of Rate of Interest – Like the classical theory, the neo- classical theory of interest also admits the possibility of zero rate of interest and that there can be no minimum limit to the rate of interest.

9. Scope of the Theory – The loanable funds theory is also stated essentially in the traditional classical terms and is founded on the unrealistic assumption of full employment.

Relative Importance – Neoclassical Theory – The loanable theory, which is stated in real as well as money terms, is an improved and more realistic version of the classical theory of interest. It recognizes the active role of money in the modern world. It also takes into account hoarding as a factor affecting the demand for loanable funds.

But, both the classical and neo-classical theories are special theories based on the assumption of full employment, wrongly regard the rate of interest (and not the income level) as the equilibrating force between saving and investment and, above all, are indeterminate theories due to their neglect of the importance of income level.

Difference # Keynesian Theory:

1. Definition of Interest – According to Keynes, interest is a reward for parting with liquidity.

2. Nature of Interest – According to Keynes interest is a purely monetary phenomenon and the theory of interest is a monetary theory of interest.

3. Determination of Rate of Interest – According to the Keynesian theory, rate of interest is determined by the equality between demand and supply of money.

4. Demand Side – In the Keynesian theory, the demand for money means the demand for liquidity or the demand to hold money in cash for the transactions motive, the precautionary motive and the speculative motive.

The demand for transactions and precautionary motives is a constant function of income and is interest-inelastic, while the demand for speculative motive is a negative function of the rate of interest. The speculative demand for money becomes perfectly elastic at a minimum level of the rate of interest, this is called liquidity trap.

5. Supply Side – In the Keynesian theory, the supply of money is fixed and controlled by the monetary authority and is perfectly interest-inelastic.

6. Saving-Investment Equality – According to Keynes, income, and not the rate of interest, is the equilibrating force between saving and investment. Rate of interest, being a purely monetary phenomenon, brings equality between demand and supply of money.

7. Role of Money – Keynes completely departs from the classical as well as neoclassical theories and gave a purely monetary theory of interest. He considered money both as a medium of exchange and a store of value. Speculative demand for money is based on the expectations of the people about the future rate of interest. Money supply is fixed, interest-inelastic and stated in stock terms related to a specific point of time.

8. Minimum Level of Rate of Interest – An important feature of the demand for money function in the liquidity preference theory of interest is the liquidity trap. This implies that the demand for money curve becomes perfectly elastic at a certain minimum level of the rate of interest which indicates that the interest rate cannot fall below this minimum limit mainly due to the psychology of the people.

9. Scope of the Theory – Keynes considers the possibility of (under employment) equilibrium and, therefore, the Keynesian theory of interest has a larger scope, i.e., it is applicable in full employment and less-than- full employment conditions.

10. Relative Importance – In sharp contrast to the classical real theory of interest, the liquidity preference theory is exclusively a monetary theory of interest which considers interest as a purely monetary phenomenon as a link between the present and the future and recognises the dynamic role of money as a store of value.

Again, the liquidity preference theory is distinct from the loanable funds theory, which, like the classical theory, is basically a reformulation of the saving- investment theory of interest to include the elements of hoarding and bank money.

The liquidity preference theory is a more general theory than the other two theories in the sense that it is applicable to both full-employment as well as less-than-full employment situations. However, the Keynesian theory is not a complete theory since it ignores the role of real factors. It is also an indeterminate theory since it fails to consider the effects of changes in the income level.