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Home » Economics Homework Help » Microeconomics Help » Interest Classical Theory
Interest Classical Theory
This theory seeks to explain the determination of the rate of interest through the interaction of the demand for savings to make investment and the supply of savings. Since this theory explains the determination of the rate of interest by real forces such as thriftness, time preference and productivity of capital, it is also called the real theory of interest. Various classical writers differ a good deal from each other in respect of their views about interest. Some of them laid emphasis on the forces governing the supply of savings. Thus they considered interest as a price for abstinence or waiting or time preference. Some others thought the marginal productivity of capital which is a force that operates on the demand side of savings, determines the rate of interest.

Fisher and Bohm-Bawerk explained the interest with both types of factors. There is a basic assumption that is common to all classical writers. It is that all of them assume full employment of resources. In other words, in their models if more resources are to be devoted to investment, that is, to the production of capital goods, some resources have to be withdrawn from the production of consumer’s goods. According to this theory, money which is lent out to the entrepreneurs for investment in capital goods is to be made available by those who save out of their incomes. By abstaining from consumption they release resources for the production of capital goods. In order to induce people to save and refrain from consuming a part of their incomes, they must be offered some interest as a reward. To persuade them to save more, the higher rate of interest has to be offered. So far the various classical economists agreed but they differed in detail about the nature of interest.

Interest is a price for abstinence or waiting: it was Nasau Senior who pointed out that saving involved a sacrifice of abstinence and interest is a price for this sacrifice. Anyone who saves some money and is therefore able to lend it to others abstrains from consuming a part of his income and in order to induce him to do so, he must be paid interest by the borrower. It is that all of them assume full employment of resources. In other words, in their models if more resources are to be devoted to investment, that is, to the production of capital goods, some resources have to be withdrawn from the production of consumer’s goods. According to this theory, money which is lent out to the entrepreneurs for investment in capital goods is to be made available by those who save out of their incomes.

Thus, according to Senior, interest as compensation, the individuals will not like to undergo the sacrifice of abstraining from the consumption. The idea of abstinence was criticized by some economists, in particular by Karl Marx, who pointed out that the rich people who are the main source of savings are able to save without any real sacrifice of abstinence. They save because something is left over after they have indulged in consumption to their heart’s desire.

In order to avoid this criticism Marshall substituted the word waiting for abstinence. According to him, when a person saves money and lends to others, he does not abstrain from consumption for all time he merely postpones consumption. But the individual who lends his savings has to wait until he gets back the money. Thus, the person who saves money and lends it to others undergoes the sacrifice of waiting. To induce people to save and wait some price has to them as compensation for making this sacrifice. According to this view, interest is a price for waiting.

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