Theory of interest

Theory of Interest
for BBS Business Economics
By
Khemraj Subedi
Associate Professor
M.Phil in Economics
PhD Scholar in Economics
Tikapur Multiple Campus
Far Western University

Meaning of Interest
 Money that is paid in exchange for borrowing
or using another person's or organization's mon
ey is called interest.
 In simple meaning interest is a payment made
by a borrower to the lender for the money
borrowed and is expressed as a rate percent per
year.
2

Gross Interest and Net Interest:
 Gross interest is the amount paid by a borrower to a
lender as a return on capital borrowed.
 When we talk about interest, it is gross interest.
 Gross interest not only includes payment for use of
funds but also the compensation for the risk
involved in recovering the loan, return for
inconveniences, cost of managing loan etc.
 Net interest is the price paid for the use of capital
only.
 It deducts all other payments paid other than use of
capital.
3

Liquidity Preference Theory of Interest:
 Propounded by J.M. Keynes in 1936 AD.
 Published in his very well known book ‘The General
Theory.”
 Keynes, “Interest is a reward for parting with
liquidity for specified period.”
 Interest is purely monetary phenomenon and
determined by the interaction between demand and
supply of money.
 Liquidity preference means the demand for money
to hold or desire of public to hold cash. 4

 Demand for money is determined by the
liquidity preference of the consumers.
 Higher the liquidity preference higher the rate
of interest and vice versa.
 Liquidity preference also shows the demand of
money.
 Hence, liquidity preference curve also shows the
demand curve of money.
 Due to inverse relationship between rate of
interest and demand for money, demand curve of
money i.e. liquidity preference curve is negative
sloped. 5

Demand for Money:
 According to Keynes, there are three motives for
the demand for money or liquidity preference,
which are:
1. Transaction Motive:
 Demand of money for day to day transactions.
 Depends on the size of money income, Lt = f (Y)
2. Precautionary Motive:
 Desire to hold cash balance in order to meet certain
unforeseen contingencies and emergencies such as
sickness, accidents, unemployment etc.
 Also depends on the level of income, Lp = f (Y) 6

 Active Cash balance (L1) = Lt +Lp = f (Y)
3. Speculative Motive:
 Demand for holding cash to make speculative gains
out of the purchase and sale of bonds and securities
due to future changes in rate of interest.
 It is determined by rate of interest and bond prices.
 It is inverse function of interest rate.
 Speculative demand for money is also called as idle
cash balance.
 Idle cash balance = Lsp or L2 = f (r)
 Total demand for money (L) = L1 + L2
= (Lt +Lp) +Lsp
= f (Y) +f (r)
7

Graphically,
O Demand for Money
Rateinterest
LP curve or
demand curve for money
A
B
C
Liquidity Trap
r1
r2
r3
M1
M2 M3
8

Supply of Money:
 Central bank is responsible body for money
supply.
 Which controls and regulates supply of money.
 It refers to the total quantity of money in the
country for all the purposes at a particular point of
time.
 Supply of money remains constant is a point of
time and interest inelastic. So, supply curve is
parallel to Y-axis.
9

Determination of Rate of Interest:
 Interest rate in liquidity preference theory is
determined by the interaction between total
demand for money and total supply of money.
 It means, when negatively sloped LP-curve i.e.
demand curve for money intersects vertical
supply curve of money, it determines equilibrium
rate of interest.
 The process of determining equilibrium rate of
interest in this theory can be explained
graphically as following. 10

O Demand and supply of Money
Rateinterest
r
LP-curve
S
M
S1 S2
E
E1
E2
M1 M2
r1
r2
Determination of rate of Interest
and
effect in rate of interest with Change in Supply of Money:
11

Effect in rate of Interest with Change in
Liquidity Preference:
O Demand for Money
Rateinterest
r2
LP2
S
M
E2
LP3
LP1
r1
r3
E1
E3
12

Theory of interest

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