Criticism of the Classical Theory of Interest
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Criticism of the Classical Theory of Interest

Criticism of the classical Theory of Interest Classical Theory of Interest came in for serious criticism, especially at the hands of Keynes. The main grounds on which it is criticized are given as under:— (i) It is pointed out that classical theory of interest is based upon the assumption of full employment of resources. In other words, it assumes that an increase in the production of one thing must mean the withdrawal of some resources from the production of other things.

Criticism of the classical Theory of Interest

Classical Theory of Interest came in for serious criticism, especially at the hands of Keynes. The main grounds on which it is criticized are given as under:—

(i) It is pointed out that classical theory of interest is based upon the assumption of full employment of resources. In other words, it assumes that an increase in the production of one thing must mean the withdrawal of some resources from the production of other things. If investment is to be increased, for example, this can only be done if resources are withdrawn from the production of consumer goods. Therefore, if people are to be induced to postpone their consumption or wait for the future-enjoyment of their savings, the reward in the shape of interest must be paid.

"Within the framework of a system of theory, built on the assumption of full employment, the notion of interest as a reward for waiting or abstinence is highly plausible. It is the premise that resources are typically fully employed that lacks plausibility in the contemporary world." If at any time in the country unemployed resources are found on a large scale, there is no need for paying people to abstain from consumption, i.e., to wait in order that more resources should be devoted to the production of capital goods. Because when there is unemployment of resources, more capital goods can be produced by putting these idle resources to work and there is no need, therefore, to withdraw resources from the production of capital goods. Therefore, something other than a theory of 'waiting' or 'time preference' is needed to explain why interest is paid.

(ii) According to the classical theory of interest, more investment (produc¬tion of capital goods) can take place only by curtailing consumption. The more the reduction of consumption, more are the savings and, therefore, more the investment. But a decrease in the demand for consumer goods is likely to lessen the incentive to produce capital goods and, therefore, will affect investment adversely.

(iii) By assuming full employment the classical theory has neglected changes in the income level. By neglecting changes in the income level, the classical theory is led into the error of the viewing the rate of interest as the factor which brings about equality of savings and investment. As Keynes asserts, equality between savings and investment is brought about not by changes in the rate of interest but by changes in the level of income.

(iv) According to the classical theory, the investment demand schedule can change or shift without causing a change or shift in the savings curve schedule. For example, according to classical theory, if investment demand schedule or curve II shifts downwards, then the new equilibrium rate of interest will be determined where this new investment demand curve cuts the old savings curve which has remained unchanged. But this is wrong. As we know from Keynesian economics, the fall in investment leads to decrease in income and out of the reduced income, less is saved and, therefore, savings curve also changes. Thus, we see that classical theory ignores the effect of changes in investment on savings.

(v)The classical theory, as pointed out by Keynes, is indeterminate. The position of the savings schedule or curve depends upon the income level, that is, the position of the savings curve or schedule will vary with the level of income. There will be different savings schedules for different levels of incomes. As income rises, for example, the saving schedule or curve will shift to the right. Thus, we cannot know what the rate of interest will be unless we already know what the income level is. And we cannot know the income level without already knowing the rate of interest, since a lower interest rate will mean a larger volume of investment and so via the multiplier, a higher level of real income. The classical theory, therefore, offers no solution and is indeterminate.

 

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