ABM-Module: A- THEORIES OF INTEREST

What is Interest: There are four types of income i.e. rent, wages, interest, profit. Interest is paid for use of capital and it may be gross interest or net interest.

As per Marshall, 'Interest is the price for the use of capital in a market'. In other words, interest is that part of national income which is paid to capitalists as a reward of the services of capital. However, in Keynes opinion, interest is a reward for parting with liquidity for a specified period. Three distinct elements can be distinguished in interest:

a)           Reward for the risk involved in making the loan;

b)          Payment for the trouble involved;

c)           Pure interest, i.e., price of the capital.

Gross interest is the payment which the borrower makes to the lenders for use of money. It includes not only the net interest but reward for risk, inconvenience, pains and management.

GROSS INTEREST = Net interest + reward for risk + reward for inconvenience + reward for pains + reward for management.

Net interest on the other hand is the payment for using the capital only and does not include other elements mentioned as above.

NET INTEREST = (Gross Interest) — (Reward for Risk + Reward for inconvenience + Reward for Pains + reward for management).

Features of interest:

(i)     payment for the risk involved in making the loan;

(ii)    payment for the trouble involved;

(iii)   pure interest, that is a payment for the use of the money.

1 . At any particular time-there is a prevailing rate of interest, which many regard as a price determined like other prices in markets, by the demand to borrow in relation to the supply of loanable funds. This is pure interest.

2 . Differences in the rate of interest on different loans made during the same period of time must,therefore, be due to differences in the risk or trouble involved. Thus, the rate of interest charged by a moneylender on an unsecured loan will be higher than the rate charged by a bank to one of its customers who can offer satisfactory collateral security. Similarly, the government has generally to offer a higher rate of interest on a long-term than on a short-term loan. FACTORS AFFECTING THE RATE OF INTEREST:

a) Difference is risk perception.

b) Difference on account of credit rating of borrower.

 c)  Difference in maturity period of loan.

d) Purpose and end use of the loan.

 f)   Nature of the primary and collateral security.

 g)   Quality of third party guarantee.

IMPORTANT THEORIES OF INTEREST

A) Prof. Senior: Abstinence theory of Interest: "Interest is the reward for waiting and abstinence".

B)Fishers Time Preference Theory of Interest: Interest is the reward paid to induce people to postpone their present consumption and to lend their money.

C) Keynes Liquidity Preference Theory of Interest: Prof J.M. Keynes in his book, the General Theory of Employment, Interest and Money, has viewed rate of interest as a purely monetary phenomenon and is determined by demard for money and supply of money. According to this theory, rate of interest is determined by liquidity preference, i.e., demand of money on one side and the supply of money on the other. Demand of money means the demand for keeping money in liquid form. Thus, demand of money means liquidity preference. The term liquidity preference means the habit cf persons to keep their money in liquid form. When a person gets his income, he has to take two important decisions: a) How much to spend and how much to save, and

b) How much to save in liquid form and how much to save in non-liquid form.

The term liquid form means to keep money in the form of ready purchasing power i.e. cash or gold or any such way as can readily be converted into cash. The term non-liquid form means to invest money in iong term securities and capital goods

FACTORS AFFECTING LIQUIDITY PREFERENCE

Keynes explained interest in terms of purely monetary forces. Keynes assumed a simplified economy where there are two assets which people can keep in their portfolio balance. These two assets are:

a)    Money in the form of currency and current deposits in the banks which earn no interest,

b)   According to Keynes, rate of interest and bond prices are inversely rlated. When bondprices go up, rate of interest rises and vice versa. The demand for money by the people depends upon how they decide to balance their portfolios between money and bonds. This decision about portfolio bal?nre ran he influenced by two factors.

First, the higher the level of nominal income in a two-asset economy, more the money people would want to hold in their portfolio balance. This is because of transactions motive according to which at the higher level of nominal income, the purchases by the people of goods and services in their daily life will be relatively larger, which require more money to be kept for transactions purposes.

Second, the higher the nominal rate of interest, the lower the demand for money for speculative motive. This is firstly because a higher nominal rate of interest implies a higher opportunity cost for holding money. At higher rate of interest, holders of money can earn more incomes by holding bonds instead of money. Secondly, if the current rate of interest is higher than what is expected in the future, the, people would like to hold more bonds and less money in their portfolio. On the other hand, if the current rate of interest is low (in other words, if the bond prices are currently high), the people will be reluctant to hold larger quantity of bonds (and instead they could hold more money in their portfolio) because of the inherent fear that bond prices would ne fall in the future causing capital losses to them.

Prof. Keynes cites three motives to explain why people prefer to keep their money in liquid form. These motives are as under 1.Transactional Motives: People keep a part of their income in liquid form so that they can pay their regular expenses. Liquidity preference for transactional motives will depend upon the size of income, time of receipt and number of transactions.

2.Precautionary Motives: People keep some part of income to provide for contingencies, such as illness, accident, unemployment etc. Liquidity preference for such motives depends upon the level of income, size of family, living conditions and habit of individuals etc. 3.Speculative Motives: Some persons like to keep their money in liquid form for speculative purposes also so that they can get the advantage of changes in the rate of interest.Thus, Demand of money = Transactional motive + Precautionary motive + Speculative motive.

Liquidity preference depends upon the income and rate of interest. There is an inverse relationship between rate of interest and demand for money (liquidity preference). If the rate of interest is high, liquidity preference will be less because the people would like to invest more and more amount. If the rate of interest is low, liquidity preference will be more because the people would like to keep the money with themselves.

Other theory of Interest

Marginal Productivity theory: According to this theory, interest is paid because capital helps in production. The borrower can earn more, by using the capital. Since law of diminishing returns applies on production, the interest rate is determined by the marginal productivity of capital.

Loanable Funds Theory: According to this theory, propounded by a number of economists, the rate of interest is determined by demand and supply of loanable funds. As per the theory, interest is the price paid for use^-of loanable funds and it is fixed at a point, at which demand and supply are equal.

Keynes's Liquidity Preference Theory: '

1.              The rate of interest is a purely monetary phenomenon and is determined by demand for money and supply of money. The theory is known as Liquidity Preference Theory.

2.              According to Keynes, demand for money means demand for keeping funds in liquid form i.e. liquidity preference.

3.              According to the theory, it is natural tendency to keep savings in liquid form to the extent possible but the liquidity can be parted with for certain period. To part with the liquidity for such certain period, the interest is the reward.

4.              The demand for money may arise for a number of reasons i.e. transaction motives (day to day expenses), precautionary motives (against possibility of sudden need say for health), and speculative motive (to take advantage of possible gains).

5.              The rate of interest is determined at the that point where demand and supply are equal, which is determined by liquidity preference.

The Demand for Money in a Two-Asset Economy: According to Keynes, people can keep two types of assets in their portfolio balance. These two assets are: (1) money in the form of currency and current deposits in the banks which earn no interest, (2) long-term bonds. The decision of people to balance their portfolios between money and bonds is influenced by two factors.

1.              Level of nominal income: Higher the level of nominal income in a two-asset economy, more the money people would want to hold their portfolio balance. This is because of transaction motive according to which at the higher level of nominal income, the people will purchase more of goods and services in their daily life, which require more money to be kept for transactions purposes.

2.              Nominal rate of interest: Higher the nominal rate of interest, the lower the demand for money for speculative motive because a higher nominal rate of interest implies a higher opportunity cost for holding money. At higher rate of interest, holders of money can earn more incomes by holding bonds instead of money. Secondly, if the current rate of interest is higher than what is expected in the future, the people would like to hold more bonds and less money in their portfolio. On the other hand, if the current rate of interest is low (in other words, if the bond prices are currently high), the people will be reluctant to hold larger quantity of bonds (and instead they could hold more money in their portfolio) because of the inherent fear that bond prices would fall in the future causing capital losses to them. { It may be noted that rate of interest and bond prices are inversely related. When bond prices go up, rate of interest rises and vice versa.}

MONEY DEMAND CURVE:

1.              Quantity of money demanded increases with the fall in the rate of interest or with the increase in level of nominal income.

2.              At a given level of nominal income, a money demand curve can be drawn showing the quantity of money demanded at various rates of interest.

3.              As demand for money is inversely related to the rate of interest, the money demand curve at a given level of income, will be downward-sloping.

4.              When the level of money income increases, the curve of demand for money shifts upward.

DETERMINATION OF RATE OF INTEREST : EQUILIBRIUM IN THE MONEY MARKET

According to Keynes, the rate of interest, is determined by demand for money (Liquidity Preference) and supply of money. The factors which determine demand for money has been explained above. The supply of money, at a given time, is fixed by the monetary authority of the country.

1.              Money supply curve is represented by a vertical straight line parallel to Y axis.

2.              The money market is in equilibrium at a interest rate at which Demand curve intersects supply curve.

3.              At higher than equilibrium rate, supply of money exceeds the demand for money. The excess supply of money reflects the fact that people do not want to hold as much money in their portfolio as the monetary authority has made it available to them. In such situation, the people holding assets in money form would buy bonds and thus replace some of money in their portfolio with bonds. Since the total money supply at a given moment remains fixed, it cannot be reduced by buying bonds by individuals. Such bonds-buying spree would lead to the rise in prices of bondS. The rise in bond prices mean the fall in the rate of interest. With the fall in the interest rate, quantity demanded of money become once again equal to the given supply of money, and the excess supply of money is entirely eliminated and money market is in equilibrium.

4.              On the other hand, if the rate of interest is lower than the equilibrium rate, there will be excess demand for money. As a reaction to this excess demand for money, people would like to sell bonds in order to obtain a greater of money for holding at lower rate of interest. The stock of money remaining fiXed, the attempt by the people to hold more money balances at a rate of interest lower than the equilibrium level through sale of bonds will only cause the bond prices to fall. The fall in bond prices implies the rise in the rate of interest. Thus, the process that started as a reaction to the excess demand for money at an interest rate below the equilibrium will end up with the rise in the interest rate of the equilibrium level.

EFFECT OF AN INCREASE IN THE MONEY SUPPLY ON INTEREST RATE

1.              Rate of interest will be determined where the demand for money is in balance or equal to the fixed supply of money.

2.              Assuming no change in expectations and nominal income, an increase in the quantity of money (through buying securities by the central bank of the country from the open market), will lower the rate of interest.

If money supply is expanded, there emerges excess supply of money at the initial rate of interest. The people would react to this excess quantity of money supplied by buying bonds. As a result, the bond prices will go up which implies that the rate of interest decline. This is how the increase in money supply leads to the fall in rate of interest.

SHIFTS IN MONEY DEMAND OR LIQUIDITY PREFERENCE CURVE:

1.      The position of money demand curve depends upon two factors: (1) the level of nominal income and

(2) the expectations about the changes in bond prices in the future which implies change in interest in future.

2.           A money demand curve is drawn by assuming a certain level of nominal income. With the increase in nominal income, money demand for transactions and precautionary motives increase causing an upward shift in the money demand curve.

3. Shifts in money demand curve (or what Keynes called liquidity preference curve) can also be caused by changes in the expectations of the people regarding changes in bond prices or movements in the rate of interest in future. If some changes in events lead the people to expect a higher rate of interest in the future than they had previously supposed, the money demand or liquidity preference for speculative motive will increase which will bring about an upward shift in the money demand curve or liquidity preference curve and this will raise the rate of interest.

MODERN THEORY: HICKS — HANSEN SYNTHESIS: IS-LM CURVE MODEL

1.              Modern theory was propounded by Hicks and Hensen.

2.              According to the theory, the interest depends upon saving, investment, liquidity preference and income.

3.              The      rate      of         interest            according        to         the            theory  is         determined      by        monetary         equilibrium            and      income equilibrium.

4.              This theory is a synthesis between the Classical and Keynes' theories of interest.

5.              It has propounded an adequate and determinate theory of interest through the intersection of what are called IS and LM curves.

6.              According to Hicks and Hansen, the classical and loanable funds theories amount to the same thing. The difference between these two theories, i.e. classical and loanable funds, lies only in the meaning of savings.

7.              IS curve is derived from various saving curves at various income levels together with the given investment demand curve. This IS curve tells us what will be the various rates of interest at different levels of income, given the investment demand curve and a family of saving curves at different levels of income.

8.              LM curve is obtained from Keynes' formulation. The LM curve is obtained from a family of liquidity preference curves corresponding to various income levels together with the given stock of money supply. This is because as the level of income increases, people would like to hold more money under the transactions motive. That is, the higher the level of income, the higher would be the liquidity preference curve. With the given supply of money, the different levels of liquidity preference curves corresponding to various levels of income would determine different rates of interest. This yields LM curve, which depicts the various combinations of interest and income level, at which money market is in equilibrium.

9.              Hicks and Hansen show that with the intersection of IS and LM curves, both the interest and income are simultaneously determined. Thus the classical and Keynes' theories taken together help us in obtaining as adequate and determinate theory of interest.

DERIVATION OF THE IS CURVE:

1 As the income rises, the savings curve shifts to the right and the rate of interest, which equalizes savings and investment, falls.

2.              Since, as income increases, rate of interest falls, the IS curve slopes downward.

3.              IS curve relates the rates of interest with the levels of income at which intended savings and investment are equal. In other words, the IS curve depicts the various combinations of levels of interest and income at which, intended savings equal investment; goods-market is in equilibrium.

4.              Since with the increase in income the savings curve shifts to the right, its intersection with the investment demand curve will lower the rate of interest.

5.              The level of income and rate of interest are inversely related. That is, the IS curve slopes downward.

6.              Further, the steepness of the IS curve depends upon the elasticity or sensitiveness of investment demand to the changes in rate of interest. A given change in interest will produce a large change in investment and thereby cause a large change in the level of income.

7.              Thus when investment demand is greatly elastic or highly sensitive to the rate of interest, the IS curve will be flat (i.e. less steep). On the other hand, when investment demand is not very sensitive to the changes in rate of interest, the IS curve will be relatively steep.

8.              The      *position          of         IS         curve   and      changes            in         its        level     are       determined      by        the       level            of         autonomous expenditure

such as government expenditure, transfer payments, autonomous investment. If the government expenditure or any other type of autonomous expenditure increases, it will increase the equilibrium level of income at the given rate of interest. This will cause the IS curve to shift to the right. A reduction in government expenditure or transfer payments will shift the IS curve to the left.

DERIVATION OF THE LM CURVE FROM KEYNES' LIQUIDITY PREFERENCE THEORY

1.              The LM curve can be derived from the Keynesian liquidity preference theory of interest.

2.              Liquidity preference or demand for money to hold depends upon transaction motive and speculative motive.

It is the money held for transactions motive which is a function of income. The greater the level of income, the greater the amount of money held for transactions motive and, therefore, the higher the level of liquidity preference curve.

4.              A family of liquidity preference curves can be drawn at various levels of income. The intersection of these various liquidity preference curves, corresponding to different income levels with the supply curve of money fixed by the monetary authority, would give the LM curve that relates the rate of interest with the level of income as determined by money-market equilibrium corresponding to different levels of liquidity preference curve.

5.              The LM curve tells us what the various rates of interest will be (given the quantity of money and the family of liquidity preference curves) at different levels of income. But the liquidity preference curves alone cannot tell us what exactly the rate of interest will be.

6.              As income increases, liquidity preference curve shifts outward and therefore the rate of interest, which equates supply of money with demand for money, rises.

THE SLOPE AND POSITION OF THE LM CURVE

1.              The LM curve slopes upward to the right. This is because with higher levels of income, demand for money (that is, the liquidity preference curve) is higher and consequently the money-market equilibrium, that is, the equality of the given money supply with liquidity preference curve occurs at a higher rate of interest. This implies that rate of interest varies directly with income

2.              Factors that determine the slope of the LM curve include (i) Responsiveness of demand for money (i.e. Liquidity Preference) to the changes in income and (ii) Elasticity or responsiveness of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of interest.

3.              As the income increases, demand for money would increase for being for transactions motive. This extra demand for money would disturb the money-market equilibrium, and in order to restore the equilibrium the rate of interest will rise to the level where the given money supply curve intersects the new liquidity preference curve corresponding to the higher income level.

4.              In the new equilibrium position, with the given stock of money supply, money held under the transactions motive will increase whereas the money held for speculative motive will decline. The greater the extent to which demand for money for transaction motive increases with the increase in income, the greater the decline in the supply of money available for speculative motive.

5.              Given the liquidity preference schedule for speculative motive, the higher the rise in the rate of interest, the steeper the LM curve consequently.

6.              According to Keynes' liquidity preference theory, r = f (M2,L2) where M2 is the stock of money available for speculative motive and L2 is the money demand or liquidity preference function for speculative motive.

7.              The second factor which determines the slope of the LM curve is the elasticity or responsiveness of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of interest. The lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be LM curve.

8.              On the other hand, if the elasticity of liquidity preference (money-demand function) to the changes in the rate of interest is high, the LM curve will be relatively flat or less steep. 

What brings about shifts in the LM curve?:

1.              An LM curve is drawn with a given stock of money supply. Therefore, when the money supply increases, given the liquidity preference function, it will lower the rate of interest at the given level of income. This will cause the LM curve to shift down and to the right. On the other hand, if money supply is reduced, given the liquidity preference (money; demand) function, it will raise the rate of interest at the given level of income and therefore cause the LM curve to shift above and to the left.

2.              The other factor that causes a shift in the LM curve is the change in liquidity preference (money demand function) for a given level of income. If the liquidity preference function for a given level of income shifts upward, this, given the stock of money, will lead to the rise in the rate of interest. This will bring about a shift in the LM curve above and to the left. On the contrary, if the liquidity preference function for a given level of income declines, it will lower the rate of interest and will shift the LM curve down and to the right. Intersection of the IS and LM curves: Simultaneous determination of interest rate and income 1. The IS curve and the LM curve relate the two variables: (a) income, and (b) the rate of interest.

2.              Income and the rate of Interest determined together at the equilibrium rate of interest are, at the point of intersection of IS and LM curve.

3.              At this point, income and the rate interest stand in relation to each other such that (1) investment and saving are in equilibrium, and (2) the demand for money is in equilibrium with the supply of money (Le., the

desired amount of money is equal to the actual supply of money).

Thus, a determinate theory of interest is based on: (1) the investment-demand function, (2) the saving function (or, conversely, the consumption function), (3) the liquidity preference function, and (4) the quantity of money.

5. According to Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the monetary factors, that is, the demand for money (liquidity preference) and supply of money play a part in determining of the rate of interest. Any change in these factors will cause shift in IS or LM curve and will therefore change the equilibrium level of the rate of interest and income.