All the above theories of interest say that the rate of interest is determined by the interaction of Demand and Supply. Then what is the difference between the various theories?
The difference is really on the point: Demand for what and supply of what?
According to the Classical Theory, demand means the demand for savings for investment and supply means supply of savings.
According to the Loanable Funds Theory, demand and supply mean the demand for and supply of lonable funds. In this sense, supply of loanable funds includes not only savings out of current income but also bank credit, dishoarding and disinvestment and demand for loanable funds includes not only the demand for investment but also for hoarding and dis-saving.
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According to Keynesian wary, the demand for money means demand to hold money, i.e., the amount of money which the public and the businessmen want to keep in the form of ready cash with them. The supply of money means the money in existence at any particular time.
Thus, it is the interpretation of the terms “demand” and “supply” which differs in each theory.
However, all these theories of the rate of interest suffer from various drawbacks and are indeterminate. Modern economists like Professors Hicks and Hansen have made a synthesis between these theories and have given an adequate and determinate theory of interest. They are of the opinion that the classical and loanable funds theories practically amount to the same thing. The difference between these two theories, i.e., classical and loanable funds, lies only in the meaning of savings.
According to them, a determinate theory of interest is based on:
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(a) The investment demand function.
(b) The saving function (or conversely the consumption function).
(c) The liquidity preference function.
(d) The quantity of money.
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Thus, we see that according to modern economists, both real factors (viz. productivity and thrift) and monetary factors (like liquidity preference and the money supply) play a part in determining the rate of interest.
Effect of Economic Progress on Interest:
As society advances, normally there arise greater facilities for saving. There are also more chances for saving capital in such communities, because in their case the difference between consumption and production is greater. Thus the rate of interest tends to decline.
On the other side, there are, no doubt, ever-increasing chances of profitable investment of capital. Demand is always expanding. Wars cut short the supply by destroying huge amounts of capital and replacements are gradual. The rate of interest thus tends to rise.
The development of productive capacity leaves a bigger surplus for use as capital, even though consumption increases. People in general have an increased capacity to save due to higher incomes.
Lastly, there are always people who will save without any regard to the rate of interest, because they earn more than is necessary to satisfy their immediate needs. This number increases with peace and security, though their savings are too small to satisfy the need for capital. Hence, on the whole, the effect of economic progress on interest is to lower it, because saving capacity of the community tends to outstrip the expanding requirements of the economy for capital.