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).
