Theories of Interest

Interest

Interest is the price paid for the use of capital. This is 'net interest' or 'pure interest'. A good example of pure interest is the interest we get on some government securities. It may be regarded as net interest. Gross interest, includes besides net interest, other things such as reward for risk, remuneration for incovenience and payment for services. Thus gross interest covers trade risks and personal risks. For example, when a money lender lends money to an Indian farmer, he charges high rate of interest because there is the risk of non - payment of the amount borrowed. There are trade risks and personal risks. Generally, people prefer to have cash balances. This is known as liquidity preference. When you lend money to someone, you cannot get it for sometime. And that is incovenience. So to compensate it, one must be paid some extra income. So, gross interest includes compensation for all the above things besides net interest.

Theories of Interest

Some of the theories of interest are (1) The Abstinence or Waiting Theory of Interest ; 2. The Agio Theory and Time Preference Theory ; 3. The Marginal Productivity Theory ; 4. Saving and Investment Theory (The classical theory) 5. Loanable Funds Theory and 6. The Liquidity Preference Theory

According to the Abstinence theory of Nassau Senior, interest is the reward for abstaining from the immediate consumption of wealth,. When people save, they abstain from present consumption. That involves some sacrifice. To make them save, interest is offered as a reward. But Marshall preferred the word, 'waiting' to 'absitinence'.

The 'Agio'theory of interest of Bohm-Bawerk tells that as the present carries a premium (agio) over the future, and as people prefer present consumption to future consumption, we have to pay a price for them by way of compensation. And that is interest. The time preference theory of Irving Fisher is more or less the same as Agio theory of interest. The marginal productivity theory of distribution is nothing but the application of the marginal productivity theory of distribution. It tells that interest tends to equal the marginal productivity of capital.

The classical theory of interest tells that the rate of interest is determined by the supply of capital which depends upon savings and the demand for capital for investment. The theory is based on the assumption that there is a direct relationship between the rate of interest, savings and direct relationship between interest and investment. The classical economists believed that savings would increase when the interest rates were high, and investment would increase with a fall in interest rate. And the equilibrium between saving and investment was brought about by the rate of interest.

Loanable funds theory (Neo - classical theory) of Interest

The loanable funds theory was developed by Knut Wicksell, Dennis Robertson and others. The loanable funds theory is wider in its scope than the classical theory of interest. The term 'loanable funds' includes not only saving out of current income but also bank credit, dishoarding and disinvestments. But by saving, the classical economists referred only to saving out of current income. We know now that bank credit is an important source of funds for investment.

In the classical theory, saving was demanded only for investment. But according to loanable funds theory, the demand for funds arose, not only for investment but also for hoarding wealth.

The classical theory regarded interest as a function of saving and investment, (r = f (S.I.) But, according to loanable funds theory, the rate of interest is a function of four variables, i.e r = f (1,S M.L.) where r is the rate of interest, I = investment, S = saving, M = bank credit and L = desire to hoard or the desire for liquidity.

In Fig. The Curve 'S' represents savings, the curve 'M' represents bank credit (including dishoarded and disinvested wealth). The curve S + M represents total loanable funds at different rates of interest.

On the demand side, the curve I represents demand for investment. The curve L represents demand for idle cash balances or to hoard money. The curve I + L represents the total demand for loanable funds at different rates of interest. The market rate of interest rm is determined by the intersection of S + M curve and I + L curve. The aggregate demand for loanable funds is equal to the aggregate supply of loanable funds at this rate of interest. In the classical theory, rn which may be called the natural rate of interest is determined by the intersection of I and S curves. That is, when the rate of interest is rn, the demand for investment is equal to the supply of savings.

Criticism : There is no doubt that loanable funds theory is an improvement over the classical theory of interest. It has been criticized on the ground that it assumes that saving is a function of the rate of interest ; 2. it ignores the influence of the changes in the level of investment on employment, income and on savings.

Liquidity preference theory (Keynesian theory) of interest.

Generally people prefer to hold a part of their assets in the form of cash. Cash is a liquid asset. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. In other words, it is the reward for not hoarding.

According to Keynes, people have liquidity preference for three motives. They are 1. Transaction motive; 2. Precautionary motive; and 3. Speculative motive.

The transaction motive refers to the money held to finance day to day spending. Precautionary money is held to meet an unforeseen expenditure.

Keynes defines speculative motive as 'the object of securing profit from knowing better than the market what the future will bring forth.' Of the three motives, speculative motive is more important in determining the rate of interest. Keynes believed that the amount of money held for speculative motive would vary inversely with the rate of interest.

Keynes was of the view that the rate of interest was determined by liquidity preference on the one hand and the supply of money on the other.

In fig.  Liquidity preference is shown by L and the supply of money is represented by M and the rate of interest is indicated by r. Rate of interest is determined by the intersection of L and M curves. There will be increase in the rate of interest to r1, when there is increase in demand for money to L1 or by a decrease in the supply of money to M1.

Criticism : Keynesian theory is a general theory of interest and it is far superior to the earlier theories of interest. But critics say that Keynes has over - emphasized liquidity preference factor in the theory of interest. Moreover, only when a person has savings, the question of parting with liquidity arises. In the words of Jacob Viner, 'without saving, there can be no liquidity to surrender. The rate of interest is the return for 'saving without liquidity'.