The the theories by classical economists stating that

The goal of this
piece is to sum the theories by classical economists stating that interest
rates are determined by the supply and demand for “capital” or savings, not
money.  Although this modern theory stating
money determines the rate is very prevalent due to the work of Keynes, it seems
he, as with other modern economists, lacked an understanding of the classical theories.

            “Capital”, as stated in classical
language, is the part of money income that is devoted to earning interest or
profits. The other part of money that we are less concerned with is the money
that is consumed or hoarded in cash. Capital is beneficial for the community as
a whole; when some save their money it allows others to obtain loans and spend
these with hopes of producing more money, and in the case they do, both parties
will profit. Accumulation of capital forces a sacrifice in some way, as noted by
Nassau Senior. Abstinence is therefore associated with profits instead of
interest because there is a consideration for the material capital rather than
the money itself. The borrower of “capital” will pay interest, but in turn
should make a profit allowing him to pay this off and more, confirming the
classical argument that interest rates and profit rates move together. Thus, if
someone is borrowing money, they must be expecting to earn an income that is
greater than the interest rate of funds borrowed in order for this situation to
make sense.

            Two main pattern predictions are
derived from this classical theory of interest. 1. An increase in the level of
income, a decrease in the demand for cash balances or hoarding, and a decrease
in the rate of taxation will increase the supply of capital and decrease the equilibrium
rate of interest. 2. An increase in the expectation of profits or easier income
earning opportunities will increase the demand for capital and raise the equilibrium
rate of interest. In addition, the classical capital supply and demand theory of
interest can be explained in terms financial assets. Savers financial assets are
the supply and the borrowers desire for “capital” causes the demand for these financial

            The classic theory of interest does
not depend of the supply of money or currency but instead on the supply and
demand for “capital”. Interest rates will only be affected in the short run due
to a change in the quantity of money, but can be changed permanently due to the
supply and demand for capital. Although loans may be given in the form of
money, the purchasing power is what is most important. Regardless of how much
money banks lend out; the value of interest will not be altered. The only thing
that will change is the value of the money.

            By citing a plethora of textual
evidence from classical economists, the claims that the classical capital
supply and demand theory was inadequate can be rejected. Notably, the claims
that there was no attempt to distinguish between savings and the supply of
loans and that the loanable funds theory on interest is flawed are found to be

            We then move on to price level and
how it is determined by the supply and demand of money. The price level itself
is not determined by any particular market, but rather the weighted average of
all prices. To understand the classical theory on price level, it is broken up
into two parts, 1. The stock demand and supply of money or 2. Flow demand and

            When looking at the demand curve for
money, we see that is a rectangular hyperbola; the quantity of money actually held
depends on the level of income. When looking at the classical system, we see
the supply of money responds to its changes in value, thus the classical supply
curve is upward sloping. By observing the value of money, which is inverse to price
level, we see it is determined by the relative quantity of money used to
purchase goods and services.

            By briefly looking at modem
theories, it is seen that they tend to fall shows with their failure to
correctly interpret capital. These modern theories are instead based off of
Keynes “illegitimate framework” in relation to aggregate supply and demand.