John Maynard Keynes’s The General Theory of Employment, Interest, and Money has been the foundation for many developments of political and economic systems. One of the key elements of the Keynes system is the theory of interest rates. In the Keynesian system, the rate of interest determines not only the level of employment, but also the money supply which in turn affects the investments processes in the economy. Per Keynes’ theory of interest rates, he is making a reference to the market interest rates. This rate depends on the supply and demand of money and can be defined as “…the reward for parting with liquidity for a specified period.” It is the measure of one’s willingness to part with the liquid aspect of the money they he or she owns. According to Keynes, the primary factor to determine the interest rate depends on two options: 1) whether a person chooses to hold savings in its most liquid form (i.e. physical cash) or 2) if a person is ready to part with the possession of cash for an x period of time. The latter is often referred to as “liquidity preference.”
There are three motives for rise in the desire/liquidity of money: transaction, precaution, and speculative motives. In short, the three motives are summarized as follows:
• Transaction Demand: cash is used in to finance daily transactions. The need for money depends on an individual’s level of income because money is taken out of their incomes to be used for spending
• Precautionary Demand: because the future is uncertain, people hold cash for unforeseen circumstances that may call for an immediate need for it. This demand is also dependent on income because people with higher incomes are more able to keep liquid money at hand.
• Speculative Demand: one holds liquid assets from knowing better than what the future of the market of bonds and securities can bring forth. The prices and rate of interest fluctuate inversely.
• Total Demand for Money: sum of transaction, precautionary, and speculative demands
According to Keynes, the rate of interest is determined through the incorporation of the concept the liquidity preference and the supply of money. Interest rate is the equilibrium point of the supply and demand curves. Both curves will rise or fall depending on the certain situations, but regardless of how much they fluctuate, interest rate is still determined at the intersection of demand for and supply of money.
The Keynesian theory was not devoid from criticism. His theory was deemed indeterminable because it assumed a given level of income (which was the same criticism for the classical theory, explained further on). We would not be able to know the transaction or speculative demand for money if the level of income is unknown. When level of income changes, an individual’s liquidity preference changes as well, which in turn affects the interest rate.
On the other hand, the classical theory states that the rate of interest is determined by the supply and demand of savings/capital. It is the point in which supply of and demand for capital are equal. Because the demand for capital comes from investments and the supply comes from savings, it can also be said that the determination of interest rates falls on savings and investments. The demand for capital at any rate of interest is dependent on its productivity. When producers borrow capital for investment, they pay interest on that investment of capital. According to the Law of Diminishing Returns, as more capital is being invested, the marginal productivity of it decreases. When the interest rate is high, the demand of capital falls; when the interest rate is low, the demand of capital rises. In terms of the supply curve, a higher interest rate increases the volume of savings (which increases the supply of funds), while a lower interest rate decreases the volume of savings. The determination of the interest rate in the classical theory is the point of intersection between the aggregate supply and aggregate demand of capital. As supply and demand fluctuate, the interest rate will go up or down to fall at the point of equilibrium once again.
Like the Keynesian theory of interest rates, criticisms that pointed out the faults in the classical theory arose. Keynes himself attacked the classical theory on the basis that it was indeterminate. Because savings depends on the level of income earned, the interest rate cannot be known unless the income level is known first. However, the income level cannot be known if the interest rate is not already known. Due to the circular reasoning, Keynes concluded that the classical theory does not offer a clear and determinable solution to the problem of interest rates. Another criticism was that the classical theory treated the two determinants of interest rate (the demand and supply curves of savings/capital) as independent of each other. This means that a change in demand will not necessarily cause a shift in the supply curve. However, Keynes argued that the two curves are not independent of each other; the supply and demand curves will move accordingly and bring a change to the other.
The relationship between the Keynes and classical theory of interest rates show that both theories have various differences between the two. One of the main differences is that in the Keynesian theory, interest rate determinants are monetary factors while the determinants of the equilibrium interest rate in the classical theory are non-monetary. The classical theory also considers the interest rate to be the equilibrium between savings and investments, while the Keynesian theory says that changes in income is the equilibrium determinant for them. Income in the Keynesian varies, while the classical considers income to be fixed because it assumes full-employment equilibrium. Keynes acknowledged that every level of employment produces different income levels, which results in different amount of savings based on how much an individual makes. It is even fair to say that the classics did not consider the impact that income had on the interest rate effect. In the classical theory, the focus was mainly on supply and demand for savings.
In the classical theory, interest on bank loans were emphasized while Keynes was concerned with long-term rate interest rates on bonds and securities because the influence they have on long-term investment is of greater significance. Additionally, the rate of interest in the classical theory was the price for saving while Keynes treated it as the price of parting from liquidity (as indicated by the liquidity theory). The liquidity preference theory assumes that a person should part from their cash in order to earn interest; this interest is the reward for doing so. On the other hand, classical economists said that a person can still earn interest even if he or she does not divorce from savings, as long as he or she uses them in a productive manner e.g. investments.
In conclusion, the Keynesian and classical theory of interest rates offered different views on the determination of the rate of interest. Keynes’ book The General Theory of Employment, Interest and Money focused on a monetarist theory of the interest rate. Liquidity preference played a significant role in the demand for money which, along with the supply of money, brought the curves into equilibrium to determine interest rate. The classical theory placed emphasis on supply and demand of savings/capital for the purpose of investment. Both theories drew criticisms from external sources that deemed them to be indeterminable, yet these theories served as important foundations for the development of political and economic systems.