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Theories of Interest Rate Determination

Introduction Interest has been variously defined and interpreted. Firstly, interest was conceived by Classical economists as the earnings of capital, that is, the rate of return on Capital. In other words, marginal productivity of capital was called the rate of interest. Some Classical economists distinguished between natural or real rate of interest and the market rate of interest. The market rate of interest is the rate at which funds can be borrowed in the market, while the natural or real rate of interest is the rate of return (marginal productivity of capital on capital. !hen the natural rate of interest is higher than the market rate of interest, there will be grater investment in capital with the result that the natural rate of interest ( i.e., the rate of return on capital will fall. The e"uilibrium will be established when the natural rate of interest becomes e"ual to the market rate of interest. Though Classical economist visualised interest as marginal productivity of physical capital, physical capital has to be purchased with monetary funds. #ence interest rate becomes return on money invested in physical capital. $ut since money to be invested in physical capital has to be saved by someone, interest also becomes the price for abstinence or waiting or time preference involved in the act of saving and lending it to others for investment in physical capital. Some of the Classical economists e%plained interest rates from the standpoint of supply side, i.e, savings and therefore emphasised the role of abstinence, or waiting or time preference in the determination interest rate. &n the other hand, 'night and (.$. Clark e%plained the phenomenon of interest only from the viewpoint of demand for capital and laid stress on the productivity of capital as the determining factor of interest. &thers like Irving Fiher, $ohm)$awerk took into consideration both the demand aspects and supply factors in determining interest rates. It may be seen that the classical economists laid much stress on real factors such a thrift ( i.e., abstinence or waiting , time preference and productivity of capital in determining interest rate. Therefore, Classical theory is also known as the real theory of interest. 'eynes considered interest as a monetary phenomenon and as such, it is determined by the demand for money ( i.e., li"uidity preference and the supply of money. *ccording to 'eynes, interest is a price not for the sacrifice of waiting or time preference but the price for parting with li"uidity. Since 'eynes emphasised the role of li"uidity preference in the determination of interest rate, his theory is known as liquidity preference theory of interest. Thus, 'eynesian theory of interest is purely a monetary theory. It is worth noting that all theories of interest seek to e%plain the determination of interest rates through the e"uilibrium between the forces of demand and supply. *ccording to the Classicals, the demand for and supply of savings determine the rate of interest. Similarly, 'eynesian theory of interest e%plains the determination of interest through e"uilibrium between the demand for and supply of money.

The Classical Theory

*s mentioned earlier, classical theory seeks to e%plain interest rates through interaction of supply and demand for savings. The demand for savings come from investors and supply of savings comes from those who save out of their incomes by abstaining from consumption. In order to induce people to refrain form consuming a part of their income and to save it, they must be offered some interest, as a reward. The following are the e%planations provided by the Classical economists as to why interest rate arises+ 1. Interest is a price for abstinence or waiting It was ,asau Senior, who first pointed out that saving involves a sacrifice or abstinence and that interest is the price paid for this sacrifice. *ccording to him, the supply of capital good depends on the willingness of the consumer to abstain from consumption in order that resources would be available to produce capital goods. Thus interest arises because of the abstinence involve in the act of saving. !ithout giving him the interest as compensation, the individual will not like to undergo the sacrifice of abstaining form consumption. The idea of abstinence was criticised by some economists, in particular by 'arl -ar%, who pointed out that the rich people who are the main source of savings are able to save without making any real sacrifice of abstinence. In order to counter this criticism, -arshall substituted the term .waiting/ for .abstinence/. !hen a person saves money and lends it to others, he does not abstain from consumption for all time0 he merely postpones consumption. Interest, therefore, is a reward for such sacrifice. 2. The Agio Theory !ohm"!awer#$ %&planation of Interest'

The *ustrian economist $ohm)$awerk put forward another e%planation of interest. *ccording to him people prefer present goods to future goods of the same kind and "uantity. Therefore, there is an agio or premium on present goods as compared to future goods as people prefer present en1oyment to future en1oyment. So, interest must be paid to induce people to forgo the en1oyment of present goods in favour of goods in the future. $ohm)$awerk, gave three reasons due to which people prefer present goods to future goods. 2 3eople tend to .underestimate the future wants/ as they cannot 1udge the intensity of future wants. *lso the future is uncertain, as they also think that they may or may not live to satisfy future wants. 4 3resent wants are felt more strongly than future wants. 5 3resent goods possess a technical superiority over future goods because present good can be used to produce capital goods, which would provide a greater output of goods in the future. Thus people prefer to have present goods which can be used as capital so that they can have more goods in future. For the above reasons, interest must be offered to people to induce them to sacrifice present goods. The premium or agio paid on present good as against future goods gives rise to interest. (. Time )reference Theory or *isher$s Theory'

Irving Fisher, an *merican economist largely accepted the views of $ohm)$awerk about the nature of interest, e%cept that he criticised the concept of technical superiority of present goods over future goods. Fisher laid greater emphasis on time preference as the cause of interest. *long with time preference, he also considered the role of marginal productivity of capital as a factor that determines interest. *ccording to Fisher, interest is the compensation for the time preference of an individual. Time preference is the preference to have an e"ual amount of goods and services at one time rather than at some other time. In other words, it is the preference that an individual has for the present income or satisfaction over future income or satisfaction. The greater the preference of the individuals for the present en1oyment of good to future en1oyment of them, the higher will have to be the rate of interest paid to induce them to lend money. The degree of impatience to spend income in the present or the time preference depends on the following factors+ 2 +i,e of the income+ 3eople whose incomes are large are likely to have their present wants more fully satisfied and hence their time preference will be less. Thus, they need to be paid relatively lower rate of interest. 4 Distribution of income o-er time+ If the income increases with age, it means the future is well provided for and the impatience to spend money in the present and therefore, time preference will be greater. &n the other hand, if income decreases with age, the degree of impatience to spend money at present, and hence, time preference will be less. 5 Degree of certainty regarding en.oyment in the future + If the individual is sure of en1oyment in the future, his impatience to spend in the present will be less and the time preference will also will be less. Similarly, a man of foresight will be less impatient to spend all his income in the present. *lso, a man who e%pects to live long will be less impatient to spend his income in the present. The above three factors determine the time preference of individuals. The higher the time preference of an individual, the higher is the rate of interest that needs to be paid and vice)versa. *s said above, Fisher also regarded the productivity of capital (rate of return over sacrifice as a determinant of interest. The greater the e%pected income (productivity from capital, greater will be the rate of interest.

Determination of Interest Rates


*ccording to the classical theory, rate of interest is determined by the supply of savings and the demand for savings. *s seen above, the supply of savings is dependent on the abstinence or the waiting on the part of the savers, which makes the resources available for investment. Savings are assumed to be interest elastic in the classical system. The higher the rate of interest, the more the savings that people will be induced to make. The supply cure of saving will therefore slope upwards to the right. &n the other hand, the demand for savings comes from the entrepreneurs or firms, which desire to invest in capital goods. Such demand arises because it is advantageous to use capital in production. The actual demand for saving or capital would depend on the -arginal 6evenue 3roduct of Capital (-63' . -63' is the

increment to total revenue by employing an additional unit of capital. *s the amount of capital employed in a particular firm increases -63' declines. -63' curve thus slopes downward to the right. !hile making an investment, the entrepreneur compares the rate of interest with the -63'. #igher the rate of interest, lower will be the total demand for savings and vice versa. %/uilibrium between Demand for and +upply of +a-ings0 *s seen above, according to the classical theory, the rate of interest is determined by the intersection of the investment demand curve and the supply of savings curve. The way in which the rate of interest is determined by the intersection of investment demand and supply of savings is depicted in the following figure, where II is the investment curve and ++ is the supply curve of savings. The investment curve and the supply of savings cure intersect at point % and thereby determine 1R as the e"uilibrium interest rate. In this e"uilibrium, 12 is the amount of saving and investment. S I R2 R % 7%cess Supply

R1 7%cess 8emand + 1 2 I

*ny other level of interest will bring dise"uilibrium in the savings ) investment relationship. If the rate of interest is 1R2, for e%ample, there will be an e%cess supply of capital (savings compared to the demand for capital. Conse"uently, rate of interest would fall to &6 where supply is e"ual to demand. &n the other hand, if rate of interest is 1R1 there will be an e%cess demand for capital (savings . *s a result, there will be competition among borrowers for capital, so that interest rate would rise to the e"uilibrium rate 1R. Thus, through the rate of interest, savings and investments are brought to e"uilibrium at point %. Criticism+ The *ssumption of full employment, which underlies the classical system, is unrealistic. !hen unemployed resources are found on a large scale, there is no need for people to abstain from consumption or to wait in order that savings and investment takes place. -ore investment can be undertaken by employing the unemployed resources.

$y assuming full employment, classical theory has ignored the changes in income level and their effect on saving and investment. The level of savings depends not only on interest rates, but also on the level of income. This theory considers real factors, but ignores monetary factors such a "uantity of money, bank credit etc. *ccording to 'eynes, classical theory is indeterminate. This is because, supply of savings is dependent on the level of income. Thus we cannot know the position the savings function, unless we know the level of income and if we do not know the position of the savings function, we cannot know the rate of interest. $ut the level of income itself is dependent on the rate of interest because with changes in the rate of interest, investment will change, which will bring about changes in the level of income. #ence, we cannot know the level of income without already knowing the rate of interest. Thus interest rate is indeterminate in the classical theory. Savings out of current income are not the only source of supply of funds. 3eople usually have past (hoarded savings, which they may dis)hoard in a period and thus add to the supply of funds in the market. -oreover, classical theory ignored the role of bank credit, which is a very important source of investment funds.

3eynesian Theory of Interest


or 4i/uidity )reference Theory of Interest Rate' In his book, 9The general Theory of Employment, Interest and Money, 'eynes gave a new view of interest. *ccording to him, interest is the reward for parting with li"uidity for a specified period. * man with a given income ha to decide first how much he is to consume and how much to sae. The amount of consumption will depend on what 'eynes calls, the propensity to consume. :iven this propensity to consume, the individual will save a certain proportion of his income. #e now has to make another decision+ should he hold his savings in the form of cash or lend it; #ow much

of his resources will be held in the form of cash and how much will be lend depends upon what 'eynes calls, 9li"uidity preference<. =i"uidity preference means the demand for money or the desire of the public to hold cash. *ccording to 'eynes, the demand for money and supply of money together determine the rate of interest. The Demand for money or 5oti-es for 4i/uidity )reference'

The demand for money is a demand for li"uidity. *ccording to 'eynes, the 8emand for money (li"uidity preference arises from three motives+ Transactions motive 3recautionary motive, and Speculative motive 2. Transactions moti-e0 It relates to demand for money for current transactions of individual and business firms. 'eynes divides transactions motive into income motive and business motive. Income motive refers to the demand for cash balances of individuals who hold cash in order 9to bridge the interval between the receipt of income and it e%penditure<. -ost of the people receive their incomes once in a week or month, while the e%penditure goes on day by day. * certain amount of ready money, therefore, is kept in hand to make current payments. This amount will depend upon the individual/s income, the interval at which the income is received etc. $usinessmen and entrepreneurs also have to keep a proportion of their resources in ready cash to make payments for raw material, transport, pay wages and salaries etc. This 'eynes calls the Business Motive for holding cash. This depends on the business turn over. *ccording to 'eynes, the principal determinant of the transaction motive is income. 4. )recautionary 5oti-e0 It refers to the desire of individual and business firms to hold cash balances to meet unforeseen contingencies like accidents, sickness, etc. The money held for precautionary motive will differ with individuals and business according to their degree of financial confidence, access to credit facilities etc. It also depends on the income and level of business activity. *ccording to 'eynes, the transactions and precautionary motives are highly income elastic, but relatively interest inelastic, unless interest rate is very high. Thus the money held under these motives is a function of income and it is stated as+ -2 > =2 (? , !here -2 is the money held for transaction and precautionary motives, ? is income and =2 stands for li"uidity preference function for Transactions and precautionary motives. 5. +peculati-e 5oti-e0 It relates to the desire to hold one/s resources in li"uid form in order to take advantage of the rise and fall in prices of bonds and securities. The decision to hold cash for speculative gains is influenced by the rate of interest. The rates of interest and bond prices are inversely related to each other. *ccording to 'eynes, if the bond prices are e%pected to rise, (that is , the interest rate is already very high and is e%pected to fall people will hold less money and they will buy bonds to sell them when their prices rise. Conversely, if bond prices are e%pected to fall, (i.e., the rate of interest is e%pected to rise people will sell bond to avoid capital loss and thus hold more cash. :iven the e%pectations about the future changes in the rate of interest, less money will be held under speculative motive at a higher current rate of interest and more money will be held at a lower rate of interest.

Thus, the demand for money for speculative motive depends upon the rate of interest and it is inversely related to changes in the rate of interest. Speculative demand for money may be stated as+ -4 > =4 (r !here -4 is the money held for speculative motive, r is the rate of interest and =4 stands for li"uidity preference function for speculative motive. Since the total demand for money -d > -2 @ -4, we may write the demand for money e"uation as+ -d > =2(y @ =4 (r . Thus, the total demand for money is a function of income and the rate of interest. :iven the level of income, the demand for money varies inversely with the rate of interest. This relationship can be e%plained with the help of the following diagram+ *ig.2

=?2

=?4

6ate of Interest

64 62

6A & ,2 ,4 ,5 8emand for -oney

In the above diagram, li"uidity preference curve =?2 shows the demand for money (or li"uidity preference at various rate of interest when the income is assumed to be ?2. !hen the income rises from ? 2 to ?4, the li"uidity preference curve shifts to =?4. Thus, =?4 shows the demand for money at various interest rates, when the level of income is assumed to be ?4. The following conclusions can be drawn from the above diagram+ 2. 3eople will demand more money at lower rate of interest than at higher rate of interest, if the income is constant. Thus, in the diagram, at ? 2 level of income, and r4 rate of interest, &,2 amount of money is demanded. !hen the interest rate falls to r2, the amount of money demanded rises to &,4, the income remaining constant at ?2. 4. *t a given rate of interest, when income increases more money will be demanded due to increase in transactions and precautionary demand for money, which rises with level of income. #ence at r2 rate of interest, an increase in income from ?2 to ?4 will increase the demand for money from &,4 to &,5.

5. !hen the rate of interest falls to rA, the li"uidity preference curve becomes perfectly elastic and it indicates the .li/uidity trap$. =i"uidity trap shows that at very low levels of interest rates, the demand for money is infinite. Determination of the Rate of interest through Interaction of 4i/uidity )reference demand for money' and the +upply of 5oney *ccording to 'eynes, the demand for money, i.e., the li"uidity preference, and the supply of money determine the rate of interest. The supply of money is determined by the policies of the :overnment and Central $ank of the country. #ow the rate of interest is determined by the e"uilibrium between li"uidity preference (demand for money and the supply of money is shown in the following figure+(Fig.5 6 Rate of Interest R2 R1 4) 1 21 22 Demand for 8 +upply of 5oney In the above figure, =3 is the curve of li"uidity preference. In other words, =3 curve shows the demand for money. The vertical line ,2S shows the initial supply of money and ,/S/ shows the supply curve of money after an increase in the money supply. To begin with the e"uilibrium between the demand for money (li"uidity preference and supply of money is at 7 2. *t this point, the demand for money e"uals the supply of money, i.e., &,2 and the e"uilibrium rate of interest &r4 is established. *n increase in the supply of money, will lower the rate of interest. For e%ample, when the "uantity of money increases from &,2 to &,4, the rate of interest falls from &r4 to &r2 and the new e"uilibrium point is denoted by 7 4. :iven the money supply, if the demand for money increases, the li"uidity preference curve shifts upwards and the rate of interest will rise. This is shown in Fig.B. 7 + +$ Fig.5

*ig.9. 6

Rate of Interest r2 r2

+$

4)2 =32 1 21 22 Demand for 8 +upply of 5oney 7

:iven the money supply &,2 (vertical line ,2S and the li"uidity preference curve =32, e"uilibrium interest rate is established at &r2. !hen the li"uidity preference curve shifts upwards to =34, the rate of interest increases from &r2 to &r4. If along with the increase in li"uidity preference, money supply also increases, interest rates will remain at &r2. In the above diagram, increase in money supply is shown by the shift in the vertical line ,2S to ,4SC. This line intersects with the new li"uidity preference curve =34 at point 75, and the interest rate remains at &r2, in spite of the shift in the li"uidity preference curve from =32 to =34. Thus, if "uantity of money is increased proportionately to the increase in li"uidity preference, the rate of interest will not rise. The monetary authorities may help increase investments and income by bringing down the rate of interest through increased money supply. $ut in conditions of depression the interest rate may already be very low, and the economy may be in a li"uidity trap. In such a situation, it may not be possible to bring down the interest rates further through increased money supply as all of the additional money supply will be held as speculative balances by the people. Critical Appraisal of 4i/uidity )reference Theory 2. 3eynes ignored the role of real factors in the determination of interest rates . 6eal factors like productivity of capital, and thriftiness or savings also play an important role in the determination of interest rates. !hen investment demand increases due to greater profit prospects, or in other words, when the marginal productivity of capital increases, there will be greater demand for investment funds and this will push up the rate of interest. Similarly, if the propensity to consume of the people increases, savings would decline. *s a result, supply of funds in the market will decline, which will raise the interest rate. 'eynesian theory does not take into account the above factors. 4. 3eynesian theory is also indeterminate. The demand for money on account of transactions and precautionary motives are dependent on the level of income. Thus we cannot know the demand for money (or the li"uidity preference curve unless we know the level of income first. #ence, the demand for money and supply of money curve by themselves cannot give us the interest rates unless we already know the level of income.

5. 2o li/uidity without sa-ing. *ccording to 'eynes, interest is a reward for parting with li"uidity and in no way a compensation and inducement for saving. $ut without saving, there will be no funds available to be kept in li"uid form. #ence there can be no li"uidity without saving. Therefore, the rate of interest is vitally connected with savings, which 'eynes ignored in his theory. B. Inconsistent with facts. *ccording to 'eynes/s li"uidity preference theory, the rate of interest should be highest during depression because the li"uidity preference is strongest during that time. $ut in reality the rate of interest is lowest in a depression. Similarly, the rate of interest should be lowest during inflation because the preference for li"uidity is lowest. $ut in reality the rate of interest is highest during inflationary period. From the above, it may be seen that 'eynesian theory of interest is also not without flaws. $ut the importance 'eynes gave to li"uidity preference, especially speculative motive, as a determinant of interest rate is a significant addition to the theory of interest rates. =ater theories incorporated the li"uidity preference concept in their theories to make it more complete.

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