Classical economists propounded the theory of demand and supply for determining the interest rate. Like commodity price determination interest rate is also determined by the demand for capital and supply of capital. The interest rate in determined at that point where demand for capital becomes equal to supply of capital.
Demand for capital: Capital is demanded for its productivity. Demand for capital is demanded for its productivity. Demand for capital refers to the demand for investment. As more and more capital is used marginal productivity of capital declines. Hence, producer will use capital till that point where marginal productivity of capital declines and becomes equal to rate of interest. According to classical economists, when interest rate talls, demand for capital increases and vice versa. Hence capital demand curve declines from left to right (fig)
Supply of capital: Supply of capital depends upon saving. Saving is that part of income which is not spent on consumption, supply of savings depend on real factors like abstinence, waiting or time preference of consumption. The change in these real factors brings change in savings. High interest rate induces savings and vice versa. Hence, supply curve of capital (or saving)is upward sloping from left to right (fig) Interest Rate Determination : Demand-supply Equilibrium: Interest rate is determined at the point where demand for capital (i.e.,investment) becomes equal to supply of capital (i.e,saving). In fig, investment curve DD and saving curve SS cut each other at point E where interest rate or is determined.
