This theory was propounded by classical economists.

This theory was later developed by the economists such as Marshall, Pigou, Walras, Taussig and Knight. This theory is also called saving investment theory or demand and supply theory. The basic idea of this theory is that the demand for capital and supply of capital determine the rate of interest. The rate of interest is determined at a point where demand for capital is equal to supply of capital. The demand for capital arises from investment and the supply of capital arises from savings. Since this theory explains the determination of rate of interest by real forces such as thrift, time preference and productivity of capital, it is also called the real theory or non-monetary theory of interest. Demand for Capital The capital or savings is demanded because of its productivity. The marginal productivity of capital diminishes as more arid more of it is used for production. The marginal product curve of capital slopes downwards from left to right. Because of this the demand curve of capital slopes downwards from left to right. This means that lower the rate of interest, the greater shall be the demand for capital. Supply of Capital The supply of capital comes from savings. The supply of savings is affected by rate of interest. Higher the rate of interest, higher shall be the volume of savings and lower the rate of interest; lower shall be the volume of savings. Hence, the supply curve of savings or capital rises upward from left to right. Determination of Rate of Interest The rate of interest is determined by the equilibrium of demand and supply. This can be illustrated by the help of following table:

As shown in the table, demand for capitals as well as supply of capital are equal, Rs 60 at 3 percent rate of interest. So, 3 percent is the equilibrium rate of interest. This rate of interest will prevail in the market. At any other interest rate, either demand or supply will be higher and there will not be equilibrium rate of interest. As for example, at 2 percent rate of interest demand for capital (Rs 80) exceeds supply of capital (Rs 40). It will push interest rate upward. Similarly, at 4 percent rate of interest supply of capital (Rs 80) exceeds the demand for capital. It will push down the interest.

The determination of rate of interest can be illustrated by the figure below.

The rate of interest in determined by the equality of demand for capital and supply of capital or saving and investment. In the figure SS is the supply curve and II is investment curve, which represents demand for capital. These two curves intersect at point E. The demand and supply are equal, Rs. 60 at point E. Hence, or, 3 percent rate of interest is determined 3 percent is the equilibrium rate of interest. There cannot be equilibrium at any other rate of interest. As for instance, at 4% rate of interest supply of capital exceeds demand. This will push interest downward. Likewise, at 2% rate of interest demand for capital exceeds supply. This will push interest upward. Eventually, 3% rate of interest will prevail in the market. If the change occurs either in demand or supply, the demand curve or the supply curve shifts. Consequently, there is change in equilibrium rate of interest. Criticisms The classical theory has been criticized on various grounds by many economists. J .M. Keynes is the prominent critic of this theory. Some of the criticisms are as follows: 1. Assumption of Full Employment This theory is based on the assumption of full employment of resources. Because only in the condition of full employment interest should be paid to encourage people to supply capital for investment by curtailing, consumption. This assumption is unrealistic, since, the unemployment of resources can be found. 2. Saving and Investment not Interest-elastic Unlike this theory the saving and the investment are not interest elastic. Saving depends on level of income. Hence, high rate of interest may not promote savings in poor community. On the Contrary, the rich people save even if the rate of interest is low. Similarly investment depends on marginal efficiency or productivity of capital. Hence the investment will be high even if the rate of interest is high if the rate of return on investment is high. 3. Indeterminate According to this theory the rate of interest is determined by demand and supply of capital. The supply of capital varies with general level of incomes. Hence, we cannot

know rate of interest unless we know the level of income. We cannot know level of income unless we know rate of interest. The classical theory is, therefore, indeterminate. 4. Ignored the Created Money This theory has completely ignored the role played by created money, that credit in the determination of rate of interest. Unlike this theory rate of interest may remain constant even if the investment demand increases because of the expansion of bank credit. 5. Price for not hoarding According to this theory interest is the price paid for not spending the income. But according to Keynes, interest is not the reward for not spending, but is the price paid for not hoarding. 6. Equality of saving and Investment According to this theory, the equality between saving and investment is brought by changes in rate of interest. But according to Keynes, the changes in level of income bring equality between saving and investment. As for example, when rate of interest falls, investment increases and when investment increases, the level of income increases. When level of income increases, savings also increase.

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 nonmonetary 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. 1. Keyness Critique of the Neoclassical Theory of Saving and Investment 1. In Keynes, since consumption is a function of disposable income, and saving is income not spent, saving is also primarily a function of disposable income. S is a passive residual, determined by disposable income and the marginal propensity to consume. Keynes did not believe it was legitimate to hold income constant when analyzing aggregate saving, as in neoclassical theory. He also disagreed with the neoclassical belief that saving is primarily a function of the rate of interest. 2. Historical experience of the Great Depression (interest rates very low, no (investment). 3. S = I is the macroeconomic equilibrium condition in both Keynes and neoclassical, but in Keynes I => S through changes in Y and in neoclassical => I through changes in i. In addition, in Keynes the two may be equal at a whole range of potential levels of output and income, only one of which is full employment, while in neoclassical the two may be equal only at full employment. 4. Keynes did not believe it was legitimate to hold the state of investor expectations constant in analyzing aggregate investment, as in neoclassical theory. He also disagreed with the neoclassical view that investment is

primarily a function of the rate of interest. Expected profitability of investors and lending institutions both required for investment to take place. 5. Keynes distinguished between risk, which is calculable, and uncertainty, which is not conducive to statistical probability. He believed most important determinants of investment described by uncertainty, not risk. In neoclassical theory, uncertainty in this sense is not recognized. Also, even under risk, the 2confidence of whether one will beat the odds is subject to unpredictable variation. Mass psychology subject to waves of optimism and pessimism. 6. Business and political climate will influence investment decisions, as will many other factors, not all of which appear immediately relevant, at least on the surface. 7. In a modern capitalist economy with high-tech financial institutions and advanced instruments of credit, a pool of saving is not necessary to finance investment. Banks are private, profit-maximizing institutions and will not pass up the chance to make profits if they believe a loan will be profitable. They will always make a loan and worry about reserve requirements at the end of the day (often borrowing themselves to meet their requirements). 8. In Keynes, the rate of interest is not determined by S and I, but by the supply and demand for money. This is Keyness liquidity preference theory (more on this later). 9. Separation of ownership and management means those who own do not necessarily know the business well, and those who manage may have different interests and incentives than if they also owned. 10. Speed of asset revaluation increasingly faster and faster. Assets are revalued within the space of seconds, and ability to react immediately, without having to wait to see if a change is a temporary deviation, creates instability. Self-fulfilling prophecies become a characteristic of the system (for example, people think an assets value is going to go down, so they sell and because people sell, the value goes down).