Critically examine the Classical theory of rent.(PART-2)
Critically examine the Classical theory of rent.(PART-2)
Ans.
Features of Classical Theory:
The distinguishing features of the classical theory of interest are given below:
1. Capital Theory of Interest: In the classical theory, interest is defined as reward for the use of capital and the rate of interest is determined by the demand and supply of capital. The supply of capital is a positive and the demand for capital is a negative function of the rate of interest.
2. Real Theory: The classical theory is concerned with the real rate of interest which is determined purely by the real factors of saving and investment. The concept of real rate of interest can be defined as the money or market rate of interest less the anticipated rate of inflation. If it is assumed (as the classical theory does) that the price level is constant and everyone anticipates that it will remain constant, then the real and money rates of interest are equal.
3. Flow Theory: The theory is stated in flow terms. Total saving and total investment have been considered as flows per unit of time. In other words, the supply of saving is regarded as a flow of funds into the capital market and the demand for investment as a flow of funds off the capital market. The equilibrium of the capital market requires the equilibrium between the flows of saving and investment.
4. Equilibrating Mechanism: According to the classical theory, the rate of interest is the equilibrating force between saving and investment. Whenever there is disequilibrium between saving and investment, the equilibrium is restored through changes in the rate of interest. If at any time, saving exceeds investment (i’s’>i’d’ at Oi’ rate of interest in Figure I), the rate of interest falls and brings equality between saving and investment. On the other hand, if investment exceeds saving (i” d”>i” s” at Oi” rate of interest), the rate of interest rises and brings equality between saving and investment.
5. Positive Rate of Interest: An important feature of the classical theory of interest is that it assumes a positive real rate of interest. The theory implicitly requires that the demand and supply curves of capital intersect at a positive real rate of interest. If, for example, the two curves do not intersect at a positive rate of interest, then, at zero rate of interest, there will be excess supply of capital (Os>Od). This is a situation of general glut which implies that equilibrium is inconsistent with fill employment.
Criticisms of Classical Theory:
The classical theory of interest has been criticized by Keynes on many grounds:
1. Interest not a Reward for Saving: Keynes has criticized the classical view that interest is the reward for saving or capital on the following grounds:
(a) An individual can get interest by lending money which he has not saved but has inherited from his forefathers.
(b) If a person hoards his savings in the form of cash, he earns no interest, on the level
(c) Savings depend not only on the rate of interest but also of income, hence interest cannot be a reward for saving,
(d) Keynes regards interest as a monetary phenomenon and defines the rate of interest as a reward for parting with liquidity (or cash balances) rather than a reward for saving.
2. Saving and Investment not Interest Elastic: The classical theory assumes that saving and investment are interest elastic, i.e., sensitive to changes in the rate of interest. But it is not always so. In reality, investment depends more on marginal efficiency of capital and future expectations than on the rate of interest, particularly during periods of depression.
Similarly, savings are rarely interest elastic. People may save without any rise in the rate of interest, or may save even if the rate of interest falls to zero. In fact, savings are more influenced by the level of income than by the rate of interest.
3. Rate of Interest not Equilibrating Force : According to the classical economists, the equality between saving and investment is maintained by the interest rate adjustment mechanism. Keynes objected to this view and gave a different mechanism for restoring the equality. According to him, income, and not rate of interest, is the equilibrating force between saving and investment. Whenever saving exceeds investment, income level declines. As a result, saving falls and becomes equal to investment. Similarly, if investment exceeds saving, income level rises, saving increases and becomes equal to investment.
4. Role of Money Ignored: The classical theory of interest assumes money to be neutral, merely acting as a medium of exchange. It ignores the role of money as a store of value, i.e., it does not take in to consideration the possibility that saving may be hoarded. It also completely ignores the important role the quantity of money, the created money and the bank credit can play in the determination of the rate of interest. All these factors make the classical theory unrealistic and irrelevant in the modern dynamic world.
5. Unrealistic Assumption of Full Employment: The classical theory is unrealistic because it operates under the special conditions of full. employment. Normally, less-than full employment, and not full employment, conditions prevail in the actual world. According to Keynes, when there are unemployed resources in the economy, people need not be paid for abstaining from consumption (i.e., for saving). The problem in such an economy is to put idle resources to use rather than to withdraw already employed resources from their existing employment. Hence, under unemployment conditions, interest cannot be a reward for abstinence or waiting.
6. Discrepancy between Market and Natural Rates: The classical economists assume that discrepancy between the natural (real) and market (money) rates of interest is merely a chance and cannot exist for a long time. But, according to Wicksell, Keynes and other monetary economists, the market rate of interest normally deviates from the natural rate of interest and this deviation is due to the influence of monetary factors like creation and destruction of bank credit.
7. Narrow View of Supply of Capital: The classical economists included only saving in the supply of capital. But in reality, the supply of capital comprises of dishoarded money. Moreover, newly created money and bank credit also form important sources of supply of capital.
8. Narrow View of Demand for Capital: According to the classical theory, the demand for capital comes only from the investors for meeting investment expenditures. It completely ignores the fact that loans are also taken for consumption purposes.
9. Indeterminate Theory: Keynes criticised the classical theory of investment on the ground that it is indeterminate. According to the classical theory, the rate of interest is determined by the intersection of saving and investment curves. The position of the saving curve depends upon the level of income; saving curve shifts to the right if income increases and vice versa.
Thus, we cannot know the rate of interest unless we already know the income level. But, we cannot know income level without first knowing the volume of investment and the knowledge of the volume of investment requires the prior knowledge of the rate of interest. Thus, the classical theory of interest offers no solution; it cannot tell what the rate of interest will be unless we already know the rate of interest.
