This article will help you to learn about the difference between real theory and monetary theory of interest.
Difference between Real Theory and Monetary Theory of Interest
The theory of interest has been evolved along two distinct lines.
There is firstly, what we call the ‘pure’ or the ‘real’ theory of interest, which runs essentially ‘in nonmonetary terms, explaining the rate of interest, as the price of capital, ‘determined’ by the marginal productivity of capital in a technological sense and by certain psychological factors (time preference) influencing the relative urgency of present and future needs: Prof. Marget calls these doctrines as “real capital theories”.’
Secondly, we have what is known as the ‘monetary theory’ of the rate of interest, which is stated in terms of demand for and supply of loanable funds or credit or claims.
It is to be realized that greater part of Keynes’ criticism (The Classical Theory of Interest) is directed against the pure theory of interest and more specifically against the traditional version which explains the rate of interest by the interaction of demand for and supply of savings or capital.
It is true that with the change in circumstances and the development of modern techniques and practices of monetary authorities the impact of the study of real forces on rate of interest has diminished and economists are more interest led in monetary theory of the rate of interest. However, it would be wrong to conclude that there is any genuine conflict between the real and monetary theory: as Don Patinkin would like to determine the rate of interest in commodity market by real theory and in the bond or securities market by monetary theory. However, this is not the end of matter.
Thus, the loanable funds theory represents an improvement over classical theory in the following respects:
(i) Loanable funds theory accepts the active role played by money, while classical theory treats money as a passive factor—a veil.
(ii) The loanable funds theory is more realistic and broader in scope because it is stated in real as well as monetary terms, whereas classical theory is stated only in real terms.
(iii) Loanable funds theory takes into account the influence of bank credit and hoarding as a constituent of money supply and a factor influencing the demand for loanable funds. This was completely ignored by classical economists.