The Classical Theory of Interest Rates

The overarching theme of classical economics is that supply will equal demand if the market is allowed to operate freely. Supply and demand are brought into balance by the adjustment of the price of the good being traded. Well known classical economists include Adam Smith, David Ricardo and John Stuart Mill. In the classical theory, interest rates are determined by the interaction between savings and investment.

The amount of savings in the classical theory is directly related to the interest rate. The higher the interest rate, the more people will save. Economists view savings as unspent income, and include bank deposits and investments in stocks, bond and real estate.

When economists speak of investment, they do not mean purchasing stocks and bonds as you might initially think. They are referring to increasing capacity to deliver goods and services. For example, when a bicycle company builds a machine to produce more bicycles, that is considered to be investment. When a company invests it needs to get money.

A company can use money it has, or it can borrow, or it can sell shares. In any case, the cost of money will be a deciding factor in the investment. The cost of money is the interest rate. You may naturally wonder why the cost of money is important if the company already has lots of cash. The answer is explained by what economists call opportunity cost. The firm can always use the cash to buy bonds that pay the prevailing interest rate. Whatever projects it undertakes must make at least the market interest rate.

In the classical theory, the amount of savings and investment were equated by a fluctuating interest rate. Economists and government policy makers have found that both savings and investment are not just influenced by changes to the interest rate. Investment is also influenced by prices and government taxes and other policies. But even taking these variables into account, economists cannot explain all of fluctuations in investment. Influential British economist John Maynard Keynes hypothesized that investment is dependent on the "animal spirits" of entrepreneurs. In other words, interest rates are definitely important in savings and investment, but they don't tell the whole story.