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 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 (see the I-I curve in Fig. 34.2).
According to the classical theory, the money which is to be used for purchasing capital goods is made available by those who save from their current income. By postponing consumption of a part of their income, they release resources for production. Savings involve the element of waiting for the future enjoyment of savings.
But people prefer the present enjoyment of goods and services to the future enjoyment of them. Therefore, if people are to be persuaded to save money and to lend it to entrepreneurs, they must be offered some interest as reward. In other words, to make people overcome their time preference, inducement must be offered in the shape of interest.
The more savings the people will do, the more consumption they will have to postpone, the greater must be the rate of interest they will ask to make such a postponement worthwhile. Thus, in order to induce people to save more, a higher rate of interest must be offered.
Moreover, higher rates of interest have also to be paid if savings have to come from those persons whose rates of time-preference are relatively more strongly weighted in favor of the present satisfactions. The supply curve of capital will therefore slope upwards to the right (SS curve in Fig. 34.2).