The supply and demand theory of interest explained

The credit popularizing classical theory of interest goes to Prof. Marshall, Ac. Pigoce, Iriving Fisher. According to the classical view, rate of interest is determined by the interaction of supply of and demand for capital. Thus this theory is popularly called as the demand and supply of theory of rate of interest. Rate of interest is determined in the same way as the price of a commodity is determined by the forces of demand and supply. The equilibrium between demand for and supply of capital goes to determine rate of interest.

Demand for capital:

Capital is demanded by the investors because of its productivity. A firm or a producer demands capital as he wants to grow with production. He is prepared to pay interest on the borrowed amount because he ultimately invests it on some of the productive projects. He therefore, pays interest according to the marginal productivity of the capital.

Marginal productivity is the addition to total production employing one more unit of the capital. If marginal productivity of a capital unit is more, demand for capital will also be greater and vice versa. But marginal productivity of capital goes on diminishing with the increasing use of capital units.

If the rate of interest is less than the marginal product the borrower will demand more capital. He will continue to demand more and more capital so long as marginal productivity equal to rate of interest. If rate of interest exceeds marginal conductivity of capital the borrower can reduce borrowing. The relationship between rate of interest and demand for capital can be shown in the diagram given below

There is an inverse relationship between demand for capital and rate of interest with ‘Or’ rate of interest capital demanded is ‘OM’. But due to a fall in interest rate to the level ‘Or’, the demand for capital is ‘OM’. That is why the demand curves DD slopes downward from left to right.

“Supply of capital:

The supply of capital depends on the volume of savings and bank loans. The total saving of an economy constitutes supply of capital level of savings depends mainly on two things willingness and ability to save. Saving involves sacrifice. The saving amount constitutes capital. Thus lending of capital involves sacrifice. The capitalist has to wait. He loses immediate command over money.

He invites difficulties and inconveniences. Thus the capitalist must be paid sufficient reward to over come his deprivation. Given the level of income, the higher the rate of interest, the greater the supply of capital. The supply of capital will be less at lower rate of interest. Thus behaviour is experienced through the supply curve of capital. If the supply of capital is graphically drawn it tends to slope upward from left to right.

The supply curve ‘SS’ rises upward from left to right. It shows that supply of a commodity is interest elastic. Higher the Interest rate more will be saved for the supply of capital. Thus at ‘or’ rate of interest the supply of capital is OM, But at ‘or’ interest, supply decreases to the level OM.

The demand for capital amounts to 20 whereas the amount of supply amounts to 50 crown. Likewise at 3% interest demand amounts to 35 crores but supply amounts to 20 crores. At 10% rate of interest the demand for capital is less than supply of capital. But at 3% rate of interest the demand for capital is less than the supply of capital.

At 5% rate of interest, both the demand and supply of capital are same. Thus the rate of interest is determined at that point where there is equilibrium between supply and demand takes place. Thus 5% rate of interest is called equilibrium rate of interest. Determination of the rate of interest by the interaction of the forces of demand and supply can

In the above diagram at P both demand for and a supply of capital is equal ‘or’ is the equilibrium rate of interest and OM is equilibrium level of capital. At or rate of interest supply is greater than demand by At ‘Or₂‘ rate of interests. Supply is less than the demand by PF. At or interest rate when supply demand, rate of interest is bound to fall but at or₂ rate of interest demand is greater than supply. This leads to an increase in rate of interest. Thus ultimately ‘or’ rate of interest is established.

Criticisms of the theory:

(1) The theory is based on the full-employment assumptions. But in reality we find unemployment or less than employment. Full employment situation is an abnormal case. Thus this theory does not apply to the real world.

(2) This theory is based on long-run. The equilibrium rate of interest which is determined by forces of supply and prevails in the long run only. Keynes believed that in long-run we will all die. So that theory is inapplicable in the short period.

(3) According to classicists rate of interest is a monetary phenomenon. Thus its supply depends on monetary savings. But saving is not the only sources of capital. Bank credit and hoarded money also constitute a part of the source of capital.

(4) Monetary factors are ignored and real factors are given due consideration. Thus theory considers only real factors like productivity, waiting, saving and sacrifice. Monetary factors are not, therefore given any importance.

(5) The theory rests on the assumption that the level of income remains constant. But in reality level of income changes with the change in investment.