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Home » Economics Homework Help » Microeconomics Help » Interest Theories
Interest Theories
Interest is conceived by economists as the rate of return on capital. Some classical economists distinguished between the natural or real rate of interest and the market rate of interest. The market rate of interest is rate of return on capital investment. When the natural rate of interest is higher than the rate of interest, then there will be greater investment in capital with the result that the natural rate of interest will fall. The equilibrium will be established when the natural rate of interest becomes equal to the market rate of interest.

Since physical capital has to be purchased with monetary funds, rate of interest becomes the rate of interest over money invested in physical capital. But since money to be invested in physical capital has to be saved by someone, interest also becomes rate of return or saving. Thus, there are two concepts of interest which are related to each other. First, the term interest is used to express a rate of return earned on capital as a factor of production. The second concept of interest refers to the price which is paid by the borrowers to lenders for the use of their saving funds. When the borrowers are entrepreneurs or businessmen, who use the saving funds for investment in capital for them rate of return in physical capital is highly significant. However when we consider things from the viewpoint of lenders who save money to send to others, the concepts of interest as a price for borrowed funds is of crucial importance therefore, interest is generally defined as price for use of borrowed funds.

It is also important to note the difference between the real rate of interest and nominal rate of interest. The real rate of interest is the nominal rate of interest corrected for inflation in the economy. Thus:

Real rate of interest + nominal rate of interest – rate of inflation

For explaining the determination of rate of interest, the three theories have been put forward. First, theory of interest is classical theory of interest which explains interest as determined by saving and investment. Secondly, neo classical economists developed what is known as Loanable Funds or Neo Classical Theory of Interest. These writers consider the interplay of monetary and non monetary forces in the determination of the rate of interest. At their hands, interest theory ceased to be purely real or non monetary theory. In their view, monetary factors along with the real factors determine the rate of interest. The loanable funds theory is partly a monetary theory of interest. But monetary theory gained more recognition with the publication of Keynes general theory. According to Keynes, interest is purely a monetary phenomenon and as such it is determined by the demand for money and the supply of money. According to him, interest is a price not for the sacrifice fo waiting or time preference but for parting with liquidity.

Since he emphasized the role of liquidity the role of liquidity preference in the determination of the interest rate, his theory is known as liquidity preference theory of interest. Keynesian theory is a purely monetary theory.

It is worth nothing that all these theories of interest seek to explain the determination of the interest through the equilibrium between the forces of demand and supply. In other words, all these theories are demand and supply theories. The difference between the various theories of interest lies in the answer to question: demand for what and supply of what. According to the classical theory, rate of interest is determined by demand for savings to make investment and the supply of savings.

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