THEORY OF INTEREST

( CLASSICAL THEORY)

Meaning of Interest rate:What is interest rate?It is the rate of return on capital. In other words,

interest is the price paid for borrowed funds. It is cost to the borrower and return to the lender.

Two types of interest rate – nominal and real.Nominal interest rate – the rate at which funds can

be borrowed from the market.Real interest rate – It is the nominal rate of interest

corrected for inflation. Or

Real interest rate = Nominal interest rate – inflation rate.

Three school of thoughts for the theory of interest:1. Classical (Economists like, J.B. Clark, F.H.

Knight, Fisher, Bohm-Bawerk, N. Senior, and others): According to this school interest rate (r ) is determined by Saving (S) and Investment (I).

2. Neo-classical (Economists such as Wicksell, Ohlin, Haberler, Robertson, Viner, and others): It is also known as Loanable Funds Theory of interest. According to this school monetary and non-monetary both forces plays role in the determination of interest rate. Contd…

Continued…3. Keynes’ Theory of the rate of interest: This

theory is also known as Liquidity Preference Theory. According to Keynes the liquidity preference and the supply of money determine the rate of interest.

Details of the Classical Theory of Interest Assumptions:1. Generally there is full employment situation.2. Households are the net savers and

Producers are the net borrowers. 3. No government intervention.

Definitions of interest rateAccording to Fisher: An interest rate is the

price a borrower pays for the use of money they borrow from a lender.

Nasau Senior: The interest is compensation for the sacrifice of abstaining from consumption. Interest arises because of the abstinence involved in the act of saving.

Marshall: interest is the price for postponing consumption.

Determination of the Rate of Interest: Classical ApproachAccording to the Classical theory, rate of

interest is determined by the supply of savings and demand for it to invest.

Higher the rate of interest, higher the savings by the households. More savings means increasing rate of sacrifice, so to compensate it higher interest rate as reward. A simple saving equation is below: S = f ( r ), where S is saving and r is interest rate. Contd…

Continued…Lower the rate of interest, higher the demand

for investment by the producers. As investment increases the M.E.C decreases, therefore investment demand rises when interest rate falls. The equation for investment is: I = f ( r ), where I is investment.

The rate of interest is determined by the equality of S and I equations.

Figure-1: Equilibrium rate of interest at the intersection of S and I curves.

Explanation of Figure-1X-axis represents S&I, whereas Y-axis

represent r. Supply of saving curve and demand for investment curve are represented by S and I respectively. Equilibrium rate of interest is at the intersection of above two curves. At equilibrium the S=I and r* is the interest rate.

Limitations of the Classical Theory:1) Full employment situation is impractical.2)Income effect on saving has been ignored.3) The effect on consumption due to higher

saving is not considered.4) The Classical theory is indeterminate.