14: The Classical Theory of the Rate of Interest

What is the Classical Theory of the Rate of interest? It is something upon which we have all been brought up and which we have accepted without much reserve until recently. Yet I find it difficult to state it precisely or to discover an explicit account of it in the leading treatises of the modern classical school. [p. 175]

Nevertheless, for Keynes it means the doctrine that the rate of interest is what brings savings and investment in line. As we have seen, for Keynes savings and investment are equal by definitionand causally, the motivation to invest comes first. The classical view implies that investment requires a prior pool of savings; for Keynes investment creates the savings by raising incomes. For the classicals, a high interest rate induces savings but restrains investment. For Keynes a high interest rate may reduce savings because it restrains investment.

There is also a large strand in (neo)classical economics linking the interest rate to the marginal disutility of abstaining from immediate consumption. The implication (again, Keynes writes that he has “not found actual words to quote” [p. 176]) is that the interest rate brings the marginal disutility of ‘waiting’ in equilibrium with the marginal productivity of capital. This suggests that capitalism has a tidy mechanism for allocating exactly the right proportion of resources to increasing production for the future – no more and no less than is necessary to meet everyone’s preferences for consuming what they want to consume, when they want to consume. Keynes quotes several passages which seem to me to say this pretty much outright – I don’t know why Keynes is so reticent about accusing the classicals of making this argument.

I think this is still true today:

Certainly the ordinary man – banker, civil servant or politician – brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly – and this is an even more general belief, even to-day – each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save. [p. 177]

We have already seen where Keynes disagrees with this, in Chapter 9. Keynes accepts that the interest rate may have some impact on the marginal propensity to save. But income will have a much bigger effect, and if a higher interest rate lowers income (because it lowers investment), people will be saving a slightly larger proportion of substantially smaller incomes. Keynes accuses the classicals of ignoring this effect on the level of aggregate income. They consider the effect of changes in the interest rate on saving ‘assuming all else is equal’, but forget that it is impossible that everything else remain equal if the interest rate changes. Ceteris cannot be paribus.

Interestingly, in proving this point we get a graph, the only one in the whole book. It is the IS (investment-savings) section of what would later become known as Hicks’ IS-LM system (LM standing for liquidity preference-money). IS-LM is a bit of a bugbear for post-Keynesians as a bastardisation of Keynes, though Keynes gave some support to the interpretation himself. Here the only point is to show that the classical theory gives the IS section by itself. That is, out of any given income, a savings curve can be given linking the rate of interest to the amount of saving. This curve would be upward-sloping in saving/investment – interest space; i.e., the higher the rate of interest, the more saved. In the same space, the investment curve would slope down: the higher the rate of interest, the lower the investment. Thus the point where the curves cross gives the equilibrium interest rate and the amount saved and invested.

But Keynes points out that the two curves are interrelated, because if investment rises, income also rises. So a move along the investment curve could shift the whole savings curve. Therefore, there are a number of different equilibrium positions – the interest rate cannot be determined with reference to the propensity to save and the marginal productivity of capital alone. There is thus a need to bring in a whole other set of curves relating the state of liquidity preference and the quantity of money. Then, with the interest rate given, the classical system relating savings and investment can determine the level of income. Or, if the rate of income is given, the classical system can tell us what the rate of interest has to be. It cannot tell us both.

The alternative (neo)classical theory of the rate of interest – that it equals the marginal productivity of capital – also fails, for reasons addressed in Chapter 11: it is a circular argument. “For the ‘marginal efficiency of capital’ partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be.” [p. 184]

Appendix on the Rate of Interest in Marshall’s ‘Principles of Economics’, Ricardo’s ‘Principles of Political Economy, and elsewhere

The title says it all really – this is just a closer look at what exactly the ‘classical theory of the rate of interest’ is. It is an extension of the argument in the chapter about what the (neo)classicals imply rather than say outright in scattered observations, and about the lack ofa coherent theory. Keynes thinks their problem boils down to the fact that money is mostly ignored in their vision of economics:

The perplexity which I find in Marshall’s account of the matter is fundamentally due, I think, to the incursion of the concept ‘interest’, which belongs to a monetary economy, into a treatise which takes no account of money… Nevertheless these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system. [pp. 189-90]

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Published in: on 23 October, 2007 at 6:29 pm  Comments (1)  

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  1. Smith did not indicate accurately to a clear theory about the investment, but he dealt with investment, especially at the beginning of his criticism the Physiocratic’s ideas. Smith reached that the physiocratic’s analytical conclusion, “that investment in agriculture is more productivity than in other investment”, is illogical. But the pattern of resource investment should be determined by the force of self interest working through the market. Smith define the former in terms of investment in the investment of agriculture, in the livestock, and in the maintenance of the firm’s family, and in the services. (See, Wood, 1993)


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