Home Page                Contact Us                About Us                Privacy Policy                Terms of Use                Advertise               

 

Home Interest Theories of Interest/Why is Interest Paid?

Theories of Interest/Why is Interest Paid?

 

There are various theories which have been put forward from time to time as to why the interest is paid. The most important theories are:

 

(1) Productivity Theory of Interest.

 

(2) Abstinence or Waiting Theory of Interest.

 

(3) Austrian or Agio Theory of Interest.

 

(4) Loanable Fund Theory of Interest.

.

(5) Liquidity Preference Theory of Interest.

 

(6) Modern Theory of Interest.

 

Let us, now, examine these theories, one by one and see how they explain the economic cause of interest.

 

(1) Productivity Theory of Interest:

 

Definition:

 

Turgot and other physiocrats were of the opinion that interest is the reward for the use of capital in production. Interest is paid, they say, because capital is productive. The labor assisted by capital can produce more things than what they can do without it.

 

Example:

 

For instance, a man with the help of a machine can sew more clothes than without it. It is but Just and proper therefore that a part of the pool of wealth which the capital has produced should go to the lender of the capital. Interest is, thus, a payment for the productivity of capital.

 

Criticism:

 

This theory has been severely criticized on the following grounds:

 

(i) This theory does explain as to why the interest is paid but it throws no light as to how the rate of interest is determined.

 

(ii) According to this theory, interest is paid because capital is productive. This means that pure interest should vary in proportion to the productiveness of the capital. But the fact is otherwise. Pure interest tends to be the same in money market during the same period of time.

 

(iii) The theory only emphasizes as to why interest is demanded but it totally neglects the supply side of the capital.

 

(iv) Finally, the theory fails to explain as to how interest is paid for the loan borrowed for consumption purposes.

 

(2) Abstinence or Waiting Theory of Interest:

 

Definition:

 

This theory of interest is associated with the name of Senior. According to the theory:

 

"Interest is a reward for abstinence. When a person saves money from his income and lends it to somebody else, he in fact makes sacrifice. Sacrifice in the sense, that he abstains from consuming the whole of his income which he could have easily spent. As abstaining from consumption is disagreeable and painful, so the lender must be rewarded for this. Thus, according to Senior, interest is the reward for abstinence from the use of capital on the part of the lender".

 

This theory is rejected on the ground that saving does not necessarily involve discomfort or sacrifice. A millionaire may save and lend a major part of his income without undergoing any hardship or suffering.

 

Marshall, Realizing this flaw in Senior's definition, substituted the term waiting for abstinence. According to Marshall:

 

"Interest is the reward for waiting. When a man saves a part of his income, he simply postpones his present consumption to some future date. During a period when money is loaned, he himself might stand in need of money. But he cannot get it back from the borrower as the period of loan is fixed. He has to wait for the return of loan. In order to encourage the spirit of waiting amongst the lenders, some inducement is necessary and this inducement according to Marshall, is interest".

 

Criticism:

 

(i) The theory is criticized on the ground that it lays undue emphasis on the supply side of the problem and ignores the demand side which is equally important for explaining the economic cause of rent.

 

(ii) It is not true that all the money saved is only due to the inducement of interest. Some persons may save money even if the rate of interest is zero.

 

(3) Austrian or Agio Theory of Interest:

 

Definition:

 

The Austrian or Agio Theory of interest was first advanced by John Rao in 1834 and later on, it was developed by the Austrian economist, Bohm-Bowerk. According to Bohm-Bowerk:

 

"Interest is the premium or agio which present goods command over future goods. The reason as to why present goods are preferred over future goods are as follows:

 

Firstly, Future is shrouded in mystery and so is uncertain. Secondly, present wants are more urgently felt than the future ones. Thirdly, present goods posses a technical superiority over future goods. Keeping in view all the conditions stated above, an individual prefers present satisfaction to a future satisfaction".

 

Example:

 

For instance, you give a choice to a person either to have one bird which is in hand or two -in the bush. If the man is wise, he will prefer the bird in the hand rather than two in the bush.

 

Take another example, you give a choice to a man either to have $100 now or the payment of same amount after, say, a year. The man if he is not a lunatic will prefer the present payment. But in case you give the choice of the payment of $100 now or $130 after six months, the man may be tempted to take $130 at the future date provided he is satisfied that the extra payment of $30 compensates the sacrifice involved in postponing the present satisfaction. Interest is, thus, the payment which a borrower has to make to the tender for inducing him to put off the satisfaction of present consumption to some future date.

 

Criticism:

 

The theory is criticized on the following points:

 

(i) It attaches too much importance on the supply side of the problem and ignores the demand side.

 

(ii) The theory does not throw light as to how the rate of interest is determined.

 

(iii) It is also pointed out that interest is not paid merely because the tender must be induced. The interest is paid because the borrowers are willing and able to pay the loan.

 

(4) Loanable Fund Theory of Interest (Neo Classical Version):

 

Definition:

 

The theory was first put forward by Wicksell and later on it was elaborated by Ohlin, Robertson and Pigou, Myrdal etc. According to the neoclassical economists:

 

"The rate of interest is determined by the interaction of the forces of demand for loanable funds and the supply of it in the credit market".

 

We briefly analyze the forces behind the demand for and supply of loanable funds and then see how they interplay in the determination of the rate of interest.

 

(i) Demand for Loanable Funds: The demand for loanable funds comes from households who need money for consumption purposes and from entrepreneurs who require it for productive purposes. The total money borrowed by consumers for consumption purposes forms only a small part of the total loanable funds, while a major portion of the funds is borrowed by businessmen of all types. When an entrepreneur borrows money, he keeps in mind two things:

 

(a) the expected net return on newly invested funds, and (b) the interest which has to be paid to the lender.

 

So long as the marginal efficiency of capital is above the interest rate, the entrepreneur continues borrowing additional funds. When he finds that due to the operation of law of diminishing returns, the marginal efficiency of capital has fallen to the level of rate of interest, the entrepreneur stops borrowing additional funds. Because if he invests more, the interest rate will be higher than the marginal efficiency of capital and his profit will be adversely affected. The last unit which an entrepreneur has thought worthwhile to employ because the net revenue earned from it equals the prevailing rate of interest, is railed marginal unit and its productivity as marginal efficiency of capital. As all the units of capital employed are very similar and interchangeable to one another in a competitive market, so the rate of interest which- is paid to the marginal unit will also be paid to all other units. Thus, we conclude that on the side of demand, the rate of interest tends to be equal to the, marginal efficiency of capital.

 

(ii) Supply of Loanable Funds: The supply of loanable funds comes from savings by individuals, business concerns, discharging of idle cash balances, bank credit. Disinvestment is another source of the supply of loanable funds. All the sources of the supply of loanable funds are directly related to the rate of interest. The higher the rate of interest, the larger is the supply of the loanable funds and vice versa.

 

There is no doubt that higher rate of interest usually induces people to save more but that is not always the case. There are people in the world who will save even if the rate of interest is zero. But as their number is not very large, so the savings of these people will not meet the demand for loanable funds. Thus, rate of interest must be high to equate the supply of loanable funds with the demand for it Let us now examine with the help of the following imaginary schedule as to how the supply of loanable funds is adjusted to the demand for it.

 

Schedule:

 

Demand for Loanable Funds ($1x10000000) Rate of Interest (%)    Supply of Loanable Funds      ($1x10000000)

2

5

7

10

15

12

9

6

20

17

12

10

15

25

5

3

7

2

 

Diagram/Curve:

 

 

In this diagram (21.1) when the rate of interest is 6%, the demand for loanable funds is exactly equal to the supply of it. As the rate of interest, which equals the demand for and supply of loanable funds is 6%, so the rate of interest which will rule in the money market will be 6%. If the rate of interest is higher than 6%, the supply of loanable funds increases more than the demand for it. Competition amongst the lenders brings down the rate of interest to the level of 6%.

If interest rate is lower than 6%, then the demand for loanable funds increases more than the supply of it. Competition amongst the buyers tends to raise the rate of interest. At 6% rate of interest, the total demand for loanable funds is brought into equilibrium with the supply of loanable funds. It is the rate which compensates the borrower as well as the lender.

 

Criticism:

 

The theory is criticized on the following grounds:

 

(i) Unrealistic assumption: The theory assumes the level of national income to be constant. Actually the level of income changes with the changes in the levels of investment in the country.

 

(ii) Unrealistic integration of monetary and real factors: The theory has integrated the monetary and real factors which affect the demand for and supply of loanable funds. Actually both these factors are to be studied separately and not to be combined.

 

(iii) Assumption of full employment: The theory assumes full employment in the economy whereas less than full employment is the general rule.

 

(iv) Interest-elastic factors. The theory assumes that saving hoarding investment, etc. are related to the rate of interest Actually investment is not influenced by rate of interest alone. There are many other factors also which affect investment in the country.

 

(5) Keynesian Theory of Interest/Liquidity Preference Theory of Interest:

 

Definition:

 

J.M. Keynes in his epoch-making book the General Theory of employment, Interest and Money, has put forward a new theory of interest. According to him:

 

"Interest is not the price for waiting. It is not the remuneration necessary to call forth saving because a man may save money, bury it in his backyard and get nothing from it in the way of interest. Interest is the reward for surrendering liquidity, i.e., a reward for dispensing with the convenience of holding money immediately available".

 

Example:

 

Just to make it more clear, we take an example. Suppose, you lend a sum of $1000 to a person for six months in return for a promise to get something extra in addition to the sum borrowed. If the borrower returns you the same amount of money after six months, will you be interested to part with or lend your ready money? Well, if you are a philanthropist, then you may. But in case you are not, then some incentive must be given to you for dispensing with the convenience of holding money immediately available.

 

Interest is, thus, the reward for parting with liquid control over cash for a specific period, or we say:

 

"Interest is the payment for parting with the advantages of liquid control of money balance".

 

Here, a question can be asked as to why the need for liquidity arises when people can earn interest by lending their ready money. Keynes has given three distinct motives of demand for money or holding money in liquid form.

 

(i) Demand for Money:

 

The main components of demand for money are as under:

 

(a) Transaction motive.

 

(b) Precautionary motive.

 

(c) Speculative motive.

 

(a) Transaction motive. Transaction demand for money refers to the demand for money to hold cash balances for day to day transactions. The transaction motive relates to the desire of households and firms to keep a certain amount of cash in hand in order to bridge the interval between the receipt of income and expenditure. The transaction demand for money depends upon (i) size of income (ii) time gap between the receipt of income and (iii) spending habit of the people.

 

Formula:

 

In symbols we can write:

 

L1 = F(y)

 

Here:

 

L1 is the transaction demand for money and F(y) shows it to be a function of income.

 

(b) Precautionary motive. The precautionary motive relates to the desire of households and business concerns to hold a certain portion of the total ready money in cash in order to meet certain unforeseen or unexpected expenses like fire, theft etc. This demand for money depends upon (i) size of income, (ii) nature of the people and (iii) foresightedness of the people.

 

As transaction and the precautionary motives for holding cash depend upon income, as they are income elastic, Keynes has put them together. It is expressed in symbols us:

 

L2 = F(y)

 

Which means that the liquidity preference on account of the two motives called L2 is a function of income.

 

(c) Speculative motive. The speculative motive relates to the desire of the households and firms to keep a portion of their resources in ready cash in order to take advantage of changes in the interest rates. If people expect a rise in the rate of interest in the future, they will try to hold money in cash in order to lend it in the future. Conversely, if they expect a fall in the rate of interest, they will at once like to invest money now in order to avail themselves of the advantages of high rate of interest. Thus, we find that an expected rise in rate of interest stimulates liquidity preference and an' expected fall has the opposite effect. It is written in symbols as:

 

L3 = F(r)

 

The liquidity preference for speculative demand for money is a function of expected changes in the rate of interest.

 

We have discussed in all the three factors which exercise powerful influence on the people's desire to hold money. The first two factors, i.e. the transaction motive and the precautionary motive are not very much Influenced by; the changes in the rate of interest, but the third factor, viz, speculative motive is very sensitive to the changes in the interest rate. The major portion of money which people want to hold in the form of cash infact is meant for speculative purposes. When the rate of interest in a community is high, people hold less money in the form of cash because by lending it to other, they earn a sufficient amount of money. Conversely if the rate of interest is low, people will not be very anxious to lend money. So the total money held by individuals and business firms will be high. In short, the demand foe money to hold in cash under speculative purposes is a function of the current rate of interest. It increases as the interest rate falls and decrease as the interest rate rises. We can say that demand for money for speculative motive is a decreasing function of the rate of interest as is shown in the fig. 21.2.

 

Diagram/Curve:

 

 

In fig, 21.2, along OX is measured the demand for money which people want to hold in the form of cash and along OY is shown the rate of interest. FG is the liquidity preference curve which slopes downward from left to right. When rate of interest is high, i.e. OL, the demand for money to hold in the form of ready money or cash is OS only. When the interest rate falls to OH, then the demand for money to hold in cash increases to ON.

 

(ii) Supply of Money:

 

The supply of money depends upon the currency issued by the central bank or the policy followed by the government of the country. The supply of money consists of currency and demand deposits. In the short run, the supply of money is assumed to be constant.

Determination of the rate of interest.

 

According to J.M. Keynes:

 

The rate of interest is determined at a where demand for money is equal to the supply of money.

 

M = Sm

 

M = Total demand for money.

 

Sm = supply of money.

 

 

In the figure (21.3), the rate of interest as determined by the interaction of the forces of demand and supply of money is OR, if there is any deviation from this interest rate, it will not be stable. For example, if the interest rate is OR1 it will lead to more supply of money (by PQ) than its demand. This will lead to fall in the interest rate. The interest rate OR2 is also not stable. Here demand for money is more than its supply by P/Q1. This will lead to rise in interest rate.

 

Criticism:

 

Keynes theory of interest is criticized on the following grounds:

 

(i) Indeterminate: J M. Keynes has criticized the classical theory of interest as being indeterminate. According to him, these theories do not take income changes into account. The fact is that Keynes theory of interest itself assumes a particular level of income and does not take income changes into account. As such it is also indeterminate.

 

(ii) Ignores real factors: The theory put forward by Keynes offers only a monetary explanation of the determination of rate of interest. It altogether ignores the real factors such as marginal productivity of capital, thrift etc., which work behind the demand for money and supply of it.

 

(iii) No liquidity without saving: According to Keynes, interest is the reward for parting with liquidity. It is in no way as inducement for saving. According to Jocob Viner, it is saving which makes funds available to be kept as liquid. Without saving, there can be no liquidity to surrender. Keynes has ignored this aspect in the determination of rate of interest.

 

(iv) Interest in the short run: Keynes theory explain the determination of the rate of interest in the short run. It fails to explain the rate of interest in the long run.

 

(v) Not an integrated theory: According to Hicks, Learner, the rate of interest along with the level of income is determined by (a), marginal efficiency of capital, (b) consumption function, (c) the liquidity preference function and (d) the quantity of money function. Keynes has discussed the last two elements in his interest theory and has ignored the. first two elements. The theory of interest is, thus, not properly integrated by Keynes.

 

(6) Modern Theory of Interest/IS-LM Curve Model:

 

Definition:

 

The Modern Theory of Interest is designated as IS-LM Curves Model. Hicks-Hansen's, IS-IM curves model seeks to explain a case of joint determination of equilibrium rate of interest (r) and equilibrium level of income (y). This theory is designed to explain the joint determination of equilibrium rate of interest r and equilibrium level of income y by the interaction of the commodity market and money market. Since IS curve and LM curve indicate equilibrium in the commodity market and equilibrium in the money market respectively, so the intersection of IS curve and LM curve shows the simultaneous equilibrium in both the commodity market and money market with equilibrium rate of interest r and equilibrium level of national income y.

 

(i) Equilibrium in the Commodity Market (Real Sector), Derivation of IS curve/Diagram:

 

The equilibrium in the commodity market can be determined on the basis of following postulates:

 

Assumptions/Postulates:

 

(i) Level of Saving S is an increasing function of both the rate of interest r and level of income y. It implies that as the rate of interest r rises, savings S also rises. Likewise, as the level of income Y rises, saving S also rises. Symbolically:

 

Formula:

 

S = f (r,y), ∂s > 0 ∂s > 0

                                                                                ∂r       ∂y

 

(ii) Level of investment I is a decreasing function of the rate of interest, it implies that as the rate of interest r falls, the level of investment I rises. However, as the level of income Y rises, the level of investment I also rises. Symbolically:

 

I = f (r,y), ∂I < 0 ∂I > 0

                                                                                ∂r      ∂y

 

 

The commodity market will be in equilibrium when savings = investment, that is:

 

S = I

 

 

We show the derivation of IS curve by determining equilibrium in the commodity market in terms of equilibrium between savings S and investment I corresponding to different pairs of interest rate rand the level of income Y. Fig. 21.4(a) depicts that at level of income Y1 and rate of interest R1, saving S is equal to investment I at E1 signifying equilibrium in the commodity, market. The corresponding point to E1 is A representing S = l in fig. 21.4(b).

 

At level of income Y2 and rate of interest R2, saving S is equal to investment I at E2 denoting equilibrium in the commodity market. The corresponding point to E2 is B representing S = I.

 

Likewise, at level of income Y3 and rate of interest R3, saving is equal investment at E3 indicating equilibrium in the Commodity, market. The corresponding point to E3 is C representing S = I. In Fig. 21.4(b), by joining points A, B and C, we obtain IS curve.

 

Definition of IS Curve:

 

"Thus IS curve is that curve which shows equilibrium in the commodity market corresponding to different pairs of level of income Y and rate of interest r".

 

The IS curve slopes downward from left to right indicating the inverse relation between the rate of interest and the level of income. It is because of the fact that when rate of interest falls, the level of investment rises leading to rise in the level, of income.

 

(ii) Equilibrium in the Money Market (Monetary Section), Derivation of LM Curve:

 

The equilibrium in the money market can be determined on the basis of following postulates:

 

Assumptions/Postulates:

 

(i) The demand for money L is an increasing function of level of income Y. It means that when the level of income Y rises, the demand for money L also rises. However, the demand for money L is a decreasing function of the rate of interest r. It implies that when the rate of interest r falls, the demand for money L rises. Symbolically:

 

L = f (r,y), ∂L > 0 ∂L < 0

                                                                                ∂r       ∂y

 

(ii) The supply of money M is assumed fixed as it is exogenously determined. The money market will be in equilibrium when demand for money = supply of money, that is:

 

L = M

 

Diagram of LM Curve:

 

 

We drive LM curve by determining equilibrium in the money market in terms of equilibrium between demand for money L and supply of money M corresponding to different pairs of interest rate r and the level of income Y. Fig, 21.5(a) shows that at level of income Y1 and rate of interest r1 demand for money L and supply of money M equilibrate at E1 signifying equilibrium in the money market. The corresponding point to E1 is A representing L = M in Fig. 21.5(b).

 

At level of the income Y2 and rate of interest r2, demand for money L and supply of money M are equal at E2 denoting equilibrium in the money market. The corresponding point to E2 is B representing L = M likewise at level of income Y3 and rate of interest r3, demand for money Land supply of money M are equal at E3 indicating equilibrium in money market. The corresponding point to E3 is C representing L = M.

 

In Fig. 21.5(b), by joining points A, B and C we obtain LM curve. Thus, LM curve is that curve which shows equilibrium in the money market corresponding to different pairs of level of income Y and rate of interest r. The LM curve slopes upward from left to right indicating direct relation between level of income and the rate of interest It is due to the fact that given the stock of money supply, as the level of income rises the transaction demand for money rises pushing tap the rate of interest.

 

Simultaneous Equilibrium in the Commodity Market and Money Market:

 

After having derived IS curve and LM curve, we how make use of IS-LM curves to demonstrate simultaneous determination of both the equilibrium rate of interest and the equilibrium level of-national income.

 

 

In Fig. 21.6, IS curve and LM curve interest at E to determine the equilibrium rate of interest Or and the equilibrium level of national income OY. It is imperative to point out that it is only at Or rate of interest and OY level national income that saving is equal to investment and demand for money is equal to supply of money. If implies that it is only at rate of interest Or and level of national income OY that the economy is in equilibrium involving simultaneous equilibrium of both the real sector (commodity market) and the monetary sector (money market).

Relevant Articles:

Definition of Interest
Analysis of Gross Interest
Difference in Interest Rates and Annual Percentage Rate (APR)
Difference in Gross Interest Rates
Theories of Interest/Why is Interest Paid
 

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Rent
Wages
Interest
Profits
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance
History of Money

 

                   Home Page                Contact Us                About Us                Privacy Policy                Terms of Use                Advertise               

All the material on this site is the property of economicsconcepts.com. No part of this website may be reproduced without permission of economics concepts.
All rights reserved Copyright
2010 - 2012