Comparison between Classical and Keynesian Theories of Interest

The Keynesian theory of interest is an improvement over the classical theory in that the former considers interest as a monetary phenomenon as a link between the present and the future while the classical theory ignores this dynamic role of money as a store of value and wealth and conceives of interest as a non-monetary phenomenon.

Thus, the classicists made the serious error of ignoring the monetary element in formulating the theory of interest a monetary theory.

Thus, the classical theory of interest in comparison with Keynes' liquidity preference theory has several weaknesses. They are as under:

1. The classical theory treated interest as the price for not spending, for saving, while, in fact, as the liquidity theory points out, it is price paid for not hoarding i.e. parting with liquidity.

2. The classical theory views the demand for money exclusively in terms of investment.

It fails to consider the fact that the demand for money might also arise from the demand for hoarding, i.e., holding idle cash balances on account of the liquidity preferences.

It is the Keynesian theory of interest that recognises the important role of liquidity preference in the determination of the interest rate.

3. The classical theory is narrow in scope as it ignores the borrowing motives like hoarding or the purpose of consumption and concentrates only on savings demanded for productive purposes, i.e., real investment demand.

4. Classical economists did not pay any attention to the money supply and bank credit which can never be ignored as a determinant of the rate of interest. Keynes does pay attention to the quantity of money as a factor determining the rate of interest.

5. The classical theory is rather ambiguous and indefinite. It ignores the fact that saving is a function of income but regards it as a function of the interest rate.

This is wrong; Keynes argued that when the rate of interest goes up level of income will be less since investment will decline so savings will be less.

Keynes thus stressed the fact that saving is a function of income rather than that of the interest rate.

6. The main weakness of the classical theory is, therefore, that it assumes the level of income to be always given. This is because it assumes full-employment equilibrium.

The theory is, therefore, rejected by Keynes because it is applicable only to a case when income is fixed at a point corresponding to the level of full employment.

Keynesian theory, on the other hand, is more realistic as it considers the economies of less than full employment also.

In fine, an important distinction between the Keynesian and classical theories of interest is that the former theory is completely stock theory whereas the latter is a completely flow theory.

In some respects, the Keynesian theory is narrower in scope, compared with the classical theory. Keynes' liquidity preference theory applies to the supply and demand for money savings or money capital only whereas the classical theory applies to non-monetary capital also.

Moreover, the liquidity preference theory assumes that a person should lend capital to somebody to get interest; for then alone can one say that he has parted with liquidity and that interest is assumed to be a reward for parting with liquidity as such.

According to the classical theory, on the other hand, even if a person does not necessarily part with his savings but uses them in his own productive activity (real investment), interest will arise.

Nevertheless, we may conclude that Keynesian theory is superior to the classical theory of interest since the former is concerned with equilibrium in the real sector. Thus, in the money economy of the present world, the Keynesian theory is more realistic than the classical theory of interest.