Q.Explain the classical (real) theory of interest.
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Start your 14-day free trial to unlock the full solution →The classical (real) theory of interest, associated with early classical economists, explains the rate of interest entirely through real forces — saving and investment — treating money merely as a neutral medium of exchange with no independent influence on the interest rate.
On the supply side, the classical economists held that savings come from households postponing present consumption in favour of future consumption. This act of postponing consumption requires an effort of "abstinence" or "waiting," for which savers must be compensated; the higher the interest rate offered, the greater the incentive to save, so the supply curve of savings slopes upward with the rate of interest.
On the demand side, firms seek to borrow funds to finance investment in capital goods, driven by the expected productivity of that capital — the more productive an additional unit of capital is expected to be, the more firms are willing to pay to borrow funds for it. As more capital is invested, its marginal productivity (and hence the willingness to pay) declines, so the demand curve for investment funds slopes downward with the rate of interest. …
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