Write a note on the classical theories.

 According to the classical theory, interest is the price paid for saving of capital.

Like the value of other things, the price of saving is determined by its demand for and supply of savings. Let us consider the demand and supply sides separately.

Demand Side:

Demand for capital comes mostly from businesses. There are, of course, some people who borrow for purposes of consumption, litigation or religious or social ceremonies. But most of the capital is demanded today by entrepreneurs who use it for productive purposes. They will in no case pay for its services at a rate higher than its productivity at the margin.

Productivity goes on diminishing as more and more capital is employed in an industry. The borrower compares the prevailing rate of interest with the marginal productivity of capital, i.e., the amount added to the total output by the use of the last installment of capital. He stops where he feels the productivity to be equal to the interest paid. He will not pay more than the worth of capital to him at the margin.

When the rate falls, it becomes worthwhile to use capital in occupations of lower productivity. Thus demand for it expands. All this is true of borrowers as a whole too. Thus, it is clear that demand curve for capital (or demand for savings to buy the capital) will slope downwards towards the right

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