Classical Theory of Rate of Interest: 5 Criticism

The following points highlight the five criticisms against the classical theory of the rate of interest. The criticisms are: 1. Based on the Assumption of Full Employment 2. Ignores effect of Changes in Income Level 3. Wrongly Assumes Independence of Saving and Investment Demand Schedules 4. Savings out of Current Income not the only Source of Loanable Funds 5. Only a ‘Real’ Theory.

Criticism # 1. Based on the Assumption of Full Employment:

The classical theory assumes the prevalence of full employment which Keynes showed to be quite unrealistic and unreasonable for a capitalist economy.

The classicals, on this assumption, believed that an act of saving means abstinence or postponement of consumption.

Therefore, as D. Dillard has remarked, “Within the frame work of a system of theory built on the assumption of full employment the notion of interest as a reward for waiting or abstinence is highly plausible. It is the premise that resources are typically fully employed that lacks plausibility in the contemporary world.”

In a world with large scale unemployment of resources, as during the World Depression of 1929-34, there is no need to pay higher rate of interest to induce people to abstain from consumption or postpone it. The unemployed resources can always be used to carry out more investment.

Criticism # 2. Ignores Effect of Changes in Income Level:

In Keynes’s view, the most fundamental defect with the classical theory is its neglect of the influence of changes in income on saving and investment. The classical theory is based on & given level of income coming out of the full employment of resources.

According to Keynes, full employment of resources is rare and changes in employment and hence income take place so quite often that a theory based on a given level of employment is quite inadequate and indeterminate. The classicals believed that at a given level of income, the volume of saving out of it and the investment undertaken are brought into equality by the rate of interest.

When the rate of interest changes, it changes investment which in turn brings about a change in income. With the change in income, savings out of it also change which affects in its turn the rate of interest.

We cannot assume the savings and investment schedules to be invariant to changes in income and vice versa. The equilibrium rate of interest and the level of income are determined simultaneously and they are inter-related. With a higher level of income the saving schedule changes to cause changes in the rate of interest which changes the rate of investment and hence income again.

The process of adjustment continues thus till equilibrium is restored. By ignoring the change in the level of income, the classical theory remained indeterminate.

Criticism # 3. Wrongly Assumes Independence of Saving and Investment Demand Schedules:

An important implication of the assumption of full employment and a given level of income in the classical theory is the assumption of the independence of supply and demand schedules. This assumption is also untenable in view of the fact that when interest rate changes to change the level of investment, the level of income also changes which changes the level of savings.

A fall in the rate of interest encourages investment and this increases income and savings out of it. On the other hand, a rise of the rate of interest discourages investment, diminishes income and hence the savings out of it. The saving and the investment schedules are, thus, in Keynes view, closely interrelated. On this point, classical theory is incorrect and unrealistic.

Criticism # 4. Savings out of Current Income not the only Source of Loanable Funds:

Writers like D.H. Robertson pointed out that the classical theory considers only saving out of current income as the only source of investible funds. Current saving must be supplemented with past, hoarded saving to get at the correct supply of funds for investment. If there are unemployed resources, then even bank credit may serve as an investible fund for the production of capital goods. The neoclassical incorporated these two other sources of funds for investment and thus formulated a better theory.

Criticism # 5. Only a ‘Real’ Theory:

The classical theory takes only the real factors into consideration like the time preference and the marginal productivity of capital. It altogether neglects the monetary influences. The classical writers believed that money is merely a medium of exchange—a veil over real goods and services.

J.M. Keynes, on the contrary, held that the rate of interest is only a monetary phenomenon. It is determined by the liquidity preference of people on the one hand and supply of money on the other. The classical theory was thus only a partial explanation of the determination of rate of interest.

In short, the fundamental flaw with the classical theory was that it was built on the unrealistic assumptions of full employment and a given level of income. Lord J.M. Keynes particularly noted this and wanted a new theory which could deal with unemployed resources taking the monetary influences into account. Neoclassical writers also admitted its failure to consider the effect of bank money and dishoarding.

In this respect both the loanable funds theory and the liquidity preference theory were improvements upon the classical theory. We proceed to study both of these theories in detail. We study the loanable-funds theory first since it was just an extension of the classical ideas to meet with the points of criticism of the classical theory.