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 - ...