Interest Rate Theories: Classical, Neo-Classical, and Modern Perspectives | Economics Notes

Interest Rate Theories: Classical, Neo-Classical, and Modern Perspectives

Classical Theory of Interest

The Classical theory, developed by Ricardo, Mill, and Marshall, posits that interest is determined by real factors:

• Supply of capital stems from savings, driven by abstinence or postponing consumption56.
• Demand for capital arises from its productivity-firms borrow until returns equal the interest rate56.
• Equilibrium occurs where savings (supply) match investment (demand) at full employment, with flexible rates6.

• Critique: Ignores monetary factors and assumes automatic full employment, which Keynes later challenged46.

Neo-Classical Theory of Interest

Building on Classical ideas, Neo-Classical theory (Jevons, Marshall) introduces utility maximization and marginal analysis:

• Interest reflects time preference (preference for present consumption) and marginal productivity of capital24.
• Loanable funds theory (Böhm-Bawerk, Fisher) synthesizes savings (supply) and investment (demand) in financial markets4.
• Markets self-correct via price adjustments, emphasizing rational decision-making under perfect information2.
• Contribution: Integrates subjective preferences with capital productivity but retains full-employment assumptions24.

Modern Theory of Interest

Hicks-Hansen’s IS-LM model (1930s) merges real and monetary factors:

• IS curve (Investment-Saving): Interest rate balances savings and investment in the goods market3.
• LM curve (Liquidity-Money): Interest rate equilibrates money supply and liquidity preference3.
• Equilibrium occurs at the intersection of IS-LM, determining output and interest rates3.

• Advancement: Overcomes Keynesian limitations by incorporating both sectors, enabling analysis of fiscal/monetary policies3.

Key Comparisons

Aspect	Classical	Neo-Classical	Modern
Focus	Real factors	Utility & marginal	Real + monetary
Determinants	Savings, productivity	Time preference, productivity	IS-LM equilibrium
Critique	Ignores money	Static expectations	Short-term focus

These theories evolved to address gaps: Classical emphasized real economies, Neo-Classical added behavioral nuance, and Modern integrated monetary dynamics236.

Citations:

1. https://lkouniv.ac.in/site/writereaddata/siteContent/202005142142245382Kamna-Theories%20of%20Interest%20lectures.pdf
2. https://en.wikipedia.org/wiki/Neoclassical_economics
3. https://www.knowledgiate.com/modern-theory-of-interest-in-economics/
4. https://economicsconcepts.com/old_site/theories_of_interest.htm
5. https://www.jvwu.ac.in/documents/Classical%20Theory%20of%20Rate%20of%20Interest.pdf
6. https://courseware.cutm.ac.in/wp-content/uploads/2020/06/Classical-theory-of-rate-of-interest.pdf
7. https://pmc.ncbi.nlm.nih.gov/articles/PMC6180666/
8. https://www.ebsco.com/research-starters/business-and-management/theory-interest
9. https://www.slideshare.net/slideshow/neo-classical-theory-of-interest/240664846
10. https://www.investopedia.com/terms/t/time-preference-theory-of-interest.asp
11. https://www.lkouniv.ac.in/site/writereaddata/siteContent/202005142142245382Kamna-Theories%20of%20Interest%20lectures.pdf
12. https://www.scribd.com/document/442578766/CLASSICAL-THEORY-OF-INTEREST-180-docx
13. https://academic.oup.com/book/38904/chapter/338064757