The meaning of interest
Interest is the payment made for the use of capital in production. The compensation to the owner of capital for parting with its capital or the reward paid to someone to forego current consumption by saving his money.
The interest rate is the percentage of borrowed funds or savings paid as interest per period, usually a year.
The theories on interest rate determination include the following:
1. The Classical Theory of Interest;
2. The Loanable Funds Theory of Interest;
3. The Liquidity Preference Theory of Interest (Keynesian Theory).
Loanable Funds Theory of Interest
Loanable Funds Theory of Interest was proposed by Knut Wicksell, a Swedish economist. It is also known as the Neoclassical Theory of Interest. It is more realistic than the Classical theory because it considers bank credit as an integral part of the money supply. It also considers money as an important factor affecting the determination of interest rate.
According to this theory, the determinants of interest rate are the demand for and supply of loanable funds. Loanable fund is money to be given out as loans or credits. The cost of a loan to the borrower is, therefore, the interest rate.
Economic agents demand for loanable funds for consumption, investment and hoarding purposes. Households normally require loans for consumption while firms obtain credit facilities for the purchase of capital goods. The government borrows when it has a budget deficit, i.e. expected revenue is less than the proposed expenditure. The keeping of idle cash balance is known as hoarding. The demand for loanable funds curve is downward-sloping meaning borrowing will increase as the interest rate falls.
The supply of loanable funds is from savings (personal and corporate) bank credit and dishoarding. Higher interest rate increases savings, dishoarding and bank loans. The supply of loanable funds is represented by an upward-sloping curve because more loans would be given out if the interest rate is high.
Figure 3: Demand and supply of loanable funds
In Figure 3 above, the interest rate of RE is produced by the intersection of demand for and supply of loanable funds.
Figure 4: A decrease in demand for loanable funds
A decrease in demand for loanable funds will shift the demand for loanable funds from D1 to D2, thereby reducing the interest rate from R1 to R2 (Figure 4 above).
Shortcomings of the Loanable Funds Theory of Interest
Ignores the effect of income on savings
The Loanable Funds Theory assumes that saving is determined by only the interest rate. However, income is a major factor influencing savings, and by extension, the supply of loanable funds.
Investment is determined by marginal efficiency of capital
It is believed that the demand for loanable funds for investment purposes is interest elastic. However, investors normally compare the interest rate with the expected return from an investment to ascertain the viability of the investment. A project will be rejected if the expected return is less than the interest rate. This principle is the Marginal Efficiency of Capital.
Savings may not be motivated by the interest rate
The neoclassical school is of the opinion that a higher interest rate motivates individuals to increase their savings. In reality, people keep a savings account even though the interest rate is low as a cushion against unexpected future events. Therefore, savings may be interest inelastic.
Supply of money is usually fixed
This theory proposes that the supply of money is variable and could be increased by increasing savings. On the contrary, the supply of money is always fixed at a point in time. In fact, the change observed in the amount of cash balances people have is due to money changing hands. This is referred to as velocity of circulation of money.
Unrealistic combination of real and monetary factors
This theory makes use of real factors such as savings and the marginal productivity of capital in the determination of the interest rate. It also considers monetary factors such as bank credit and dishoarding. These two types of factors are difficult to combine in one theory.
The Liquidity Preference Theory of Interest (Keynesian Theory)
According to the Liquidity Preference Theory, interest rate is determined by the intersection of the demand for money and the supply of money. It is the rate at which the desire to hold liquid assets is equal to the volume of money in circulation. Demand for money is the preference to hold liquid assets, such as cash, as against holding other less liquid assets, such as bonds. The demand for money curve slopes downward from left to right; that is to say, demand for money decreases as interest rate increases. This is because people will keep less cash and invest in assets like bonds when the interest rate is high.
The supply of money is the total amount of money circulating in an economy. The supply of money is assumed to be fixed by the authority; therefore, it is a perfectly inelastic or vertical line.
In Figure 5 below, R is the interest rate at which demand for money (or liquidity preference) is equal to the money supply. The money supply exceeds the demand for money at any interest rate above the equilibrium interest rate (R). This will drive the interest rate down to R. Also, the demand for money surpasses the money supply at any interest rate below R; this means there is a shortage or scarcity of money. Therefore, the interest rate will increase until the equilibrium is restored.
Figure 5: Liquidity preference theory of interest
The government or central bank can increase the amount of money in circulation for the interest rate to decrease or reduce the amount of money in circulation for the interest rate to rise. An increase in money supply from MS1 to MS2 reduces the interest rate from R1 to R2. The interest rate rises from R1 to R3 when the money supply is decreased from MS1 to MS3 (Figure 6 below).
Figure 6: Effect of changes in money supply on interest rate
