Theories of Interest - Explained with Examples
Theories of Interest
1. Classical Theory of Rate of Interest
The classical theory states that the rate of interest is determined by the interaction of savings and investment in the capital market. It assumes full employment and treats interest as the price for capital.
Mathematical Example:
If savings function is S = 50 + 0.2Y and investment function is I = 200 - 5r,
Where Y is income and r is interest rate,
At equilibrium: S = I
Let’s assume Y = 1000:
S = 50 + 0.2(1000) = 250
250 = 200 - 5r → 5r = 200 - 250 = -50 → r = -10% (not realistic, so model assumes flexible Y)
2. Keynes’ Liquidity Preference Theory
Keynes proposed that the interest rate is determined by the supply and demand for money. People demand money for transactions, precautionary, and speculative motives. Interest is the reward for parting with liquidity.
Example:
If total money demand is Md = L1 + L2 = kY - hr
Assume: k = 0.25, h = 100, Y = 2000
Md = 0.25 × 2000 - 100r = 500 - 100r
Let money supply Ms = 300
At equilibrium: Md = Ms
500 - 100r = 300 → 100r = 200 → r = 2%
3. Money Demand Curve
The money demand curve shows the inverse relationship between the interest rate and the quantity of money demanded for speculative purposes. As interest rates rise, people prefer to hold bonds instead of cash.
Graphical Insight: Downward sloping curve showing higher r leads to lower Md for speculation.
4. Determination of Rate of Interest: Equilibrium in the Money Market
The interest rate is determined where money demand equals money supply.
Mathematical Example:
Md = 600 - 50r
Ms = 400
600 - 50r = 400 → 50r = 200 → r = 4%
5. Effect of an Increase in Money Supply
When the central bank increases the money supply, the vertical money supply curve shifts right. At the same money demand, interest rate falls.
Example:
Original Ms = 400, New Ms = 500
Using same demand: 600 - 50r = 500 → 50r = 100 → r = 2%
6. Shift in Money Demand or Liquidity Preference Curve
If money demand increases (due to rise in income or uncertainty), the Md curve shifts right, causing higher interest rates at the same money supply.
Example:
New Md = 700 - 50r, Ms = 500
700 - 50r = 500 → 50r = 200 → r = 4%
7. Hicks-Hansen Synthesis: IS-LM Curve Model
The IS-LM model combines the goods market (IS curve) and money market (LM curve) to determine interest rate and output.
IS Curve (Goods Market): Y = C + I + G
Let I = 400 - 50r, and planned expenditure = Y = 1000 - 50r (simplified)
LM Curve (Money Market): Md = 0.25Y - 100r, Ms = 300
At equilibrium Md = Ms → 0.25Y - 100r = 300
Solving IS and LM together:
From IS: Y = 1000 - 50r → r = (1000 - Y)/50
Sub into LM:
0.25Y - 100 × [(1000 - Y)/50] = 300
0.25Y - 2(1000 - Y) = 300 → 0.25Y - 2000 + 2Y = 300
2.25Y = 2300 → Y = 1022.22
Then r = (1000 - 1022.22)/50 = -0.444 (Again, unrealistic in classical models, but shows shift)
Conclusion
Different theories of interest highlight different factors: classical theory focuses on savings-investment, Keynes focuses on money demand and liquidity, while IS-LM combines both for equilibrium.
Labels: Interest Rate, IS-LM Model, Keynes Theory, Liquidity Preference, Money Supply, Banking Exam Notes| Chapter Number | PAPER I – INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM MODULE B: ECONOMIC CONCEPTS RELATED TO BANKING |
|---|---|
| 1. |
MODULE B: ECONOMIC CONCEPTS RELATED TO BANKING Fundamentals of Economics, Microeconomics, Macroeconomics, Types of Economies, and Supply & Demand |
| 2. | Money Supply and Inflation |
| 3. | Theories of Interest - Explained with Examples |
| 4. | Business Cycles and Economic Policies - Explained with Examples |
| 5. | National Income, GDP and Union Budget - Explained with Examples |
| QandAs/MCQs 8 | MCQs: Economics Fundamentals, Micro and Macro Concepts |
| QandAs/MCQs 9 | MCQs on Money, Money Supply, and Inflation |
| QandAs/MCQs 10 | MCQs on Theories of Interest - IS-LM, Classical & Keynesian Theory |
| QandAs/MCQs 11 | MCQs: Business Cycle, Policies, National Income |
| QandAs/MCQs 12 | MCQs: Monetary & Fiscal Policy | National Income | Union Budget |
| MODULE C: INDIAN FINANCIAL ARCHITECTURE | |
| MODULE D: FINANCIAL PRODUCTS AND SERVICES | |
| MODULE A: INDIAN ECONOMIC ARCHITECTURE | |
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