This article will help you to learn about the difference between classical and Keynesian theories of interest.
Difference between Classical and Keynesian Theories of Interest
1. The classical theory of interest is a special theory because it presumes full employment of resources.
On the other hand, Keynes theory of interest is a general theory, as it is based on the assumption that income and employment fluctuate constantly.
2. Classical regard rate of interest to be equilibrating mechanism between saving and investment. Keynes regards changes in income to be the equilibrating mechanism between them. According to Keynes, savings depend on income. Classicals regarded savings as fixed corresponding to full employment income, whereas for Keynes for every level of employment, there will be a different level of income and for different levels of income there will be corresponding savings (curves).
3. According to classicals, more savings will flow at a higher rate of interest, but according to Keynes savings will fall because the level of income will fall, for the investment will be less when the rate of interest goes up, leading to a decline in income and hence savings.
4. The element of hoarding occupies a central position in Keynes’ liquidity preference theory of interest because he considers money as a store of value also; whereas the classicals gave little importance to the element of hoarding and considered money only as a medium of exchange.
5. Classicals gave more attention to interest on bank loans, whereas Keynes was concerned with the entire loan and interest rate structure in the market and the complex of rates of interest that exist. In his theory, long-term rate of interest on loans, bonds and securities occupy greater significance as they influence long-term investment.
6. Classicals always held that savings automatically flow into investment. Keynes held just the reverse, that is, it is investment that automatically leads to saving out of current income. Further, classicals held that investment could be increased by saving more but Keynes held that investment could increase income and out of the increased income, increased savings flow.
7. An increase in thrift, which according to classicals, was a great virtue, may according to Keynes, cause income to fall reducing the volume of savings. Hence, the classical position is falsified. It is one of the great merits of “General Theory” and the Keynesian approach of liquidity preference that it once for all cleared the thinking which confused the amount saved with the propensity to save. Thus, whereas classicals were keen to retain saving to investment as determining factors, Keynes omitted them completely from his theory of interest.