Theories Of Interest

Ø  Interest is a payment made by a borrower for the use of a sum of money for a period of time.

Ø  It is one of the four types of income, the other being Rent, Wages & profit.
Ø  Three elements can be distinguished in interest:

1.  Payment for the risk involved in making the loan
2. Payment for the trouble involved
3. Pure interest, i.e. a payment for the use of money

M Keynes in his book “The General Theory of Employment, Interest & money” view that “The rate of interest is a purely monetary phenomenon & is determined by demand for money & supply of money.
This theory also known as Liquidity Preference theory
Keynes assumed that there are two- assets –
    1.       Money in the form of currency & current deposit
    2.       Long term bond

Rate of interest & Bond price are inversely related & vice-versa Higher the level of nominal income in two-asset economy, more people would want to hold in their portfolio balance i.e. in the form of cash / bank deposits.
Higher the nominal rate of interest, the lower the demand for money or more in the form of bonds.

Money demand Curve –

Quantity of money demand increase with the fall in rate of interest or with the increase in level of nominal income. So at the level of nominal income, money demand curve will be downward slopping.

According to J M Keynes – The rate of interest is determined by demand for money (liquidity preference) & supply of money.
Position of money demand curve, depend upon two factors –
   1.       Level of nominal income
   2.       Expectation about changes in bond price in the future  (which implies change in rate of interest)

IS and LM curves Theory promulgated by Sir Hon Richard Hicks and Alvin Hansen.
The IS curve and the LM curve relate the two variables -
   1.       Income
   2.       The rate of interest.
The intersection point of the two curves is the equilibrium rate of interest.
LM= Liquidity preference and Money supply equilibrium, derived from Keynes Liquidity preference theory of interest.
IS = Classical Theory