Theory of interest rate - loan theory

What is interest ? Types of interest & Rate of interest
various theory of interest
1) Classical theory
2) Loanable fund theory
their criticism and explaination

1. THEORY OF INTEREST RATE
PRESENTED BY : VAIBHAV BHALOTIA

2. TABLE OF CONTENT
Loanable theory
What is interest ?
Types of interest
Rate of interest
Classical theory

3. WHAT IS INTEREST ?
LENDER BORROWER
MONEY
INTEREST
➢In general “Interest is the price paid for making use of money for certain period of time”
➢In economics “Interest is the payment for the use of capital or loanable funds”

4. TYPES OF INTEREST
Simple interestis calculated only on the principal amount of the loan.
❑Principal ×interest rate ×n= interest
Compound interestis computed on both the principal and any interest
earned.
❑Principal ×interest rate= interest for Year One
❑(Principal + interest earned) ×interest rate= interest for Year Two
❑(Principal + interest earned) ×interest rate= interest for Year Three

5. RATE OF INTEREST
WHY RATE OF INTEREST VARIES FROM PLACE TO PLACE, INDUSTRY TO INDUSTRY,
BORROWER TO BORROWER ?
Interest rates vary according to:
✓the government's directives to the central bank to accomplish the government's goals
✓the currency of the principal sum lent or borrowed
✓the term for maturity of the investment
✓the perceived default probability of the borrower
✓supply and demand in the market
An interest rate is defined as the proportion of an amount loaned which a
lender charges as interest to the borrower, normally expressed as an annual
percentage.

6. THEORIES OF INTEREST
Determination
of
Rate of Interest
Classical theory
Loanable funds
theory

7. CLASSICAL THEORY
▪Theclassicaltheoryofinterestreferstotheviewsof“Marshall,Cassel,Taussingetc.
▪TheoryisalsoknownastheDemandandSupplytheoryofinterestbecauseitdealswith
theDemandsideaswellastheSupplyside
▪RateofInterestisdeterminedbythedemandforCapital(investment)andSupplyof
Capital(Savings).
▪Demandforcapitalcomesfromthosewhowanttoinvestinbusinessactivities.
▪Supplyofcapitalistheresultofsavings.Itcomesfromthosewhohavetheexcessof
incomeoverconsumption.

8. Demand for Capital(Investment)
❖Capital demand will be high for more productive uses first and then gradually with the increase in its
supply, will shift to less productive uses.
❖Now a very important question arises is that how much capital a person will demand because when a
person borrows money he has to pay interest on it. The answer according to this theory is that demand
for capital can be raised to a point where marginal productivity of capital becomes equal to the interest
paid on it.
❖This shows that there exists inverse relationship between demand for capital and the interest rate.
InfigurerateofinterestisOR,thedemandfor
capitalisOM.
WhentheRateofInterestfallstoOR1,thedemand
increasestoOM1.
E
E1
R
R1
D
D
MM1
Y
X
Demand for Capital or Investment
Rate of Interest
o
CLASSICAL THEORY

9. Supply for Capital(Savings)
❖Savings is the main source of capital which depends on the capacity to save, willingness to save, level of
income and rate of interest etc.
❖To a large extent, willingness to save is affected by the rate of interest. On a higher rate of interest people
save more to earn the benefits of high rate of interest. On the other hand, at the low rate of interest,
people save less.
❖Thus, we may say that there is a direct relationship between the supply of savings and the rate of
interest.
o
E1
R1
R
s
s
MM1
Y
X
Rate of Interest
E
Supply of Capital or Savings
InfigureSavingincreasefromOMtoOM1,Whenthe
rateofinterestrisesfromORtoOR1
CLASSICAL THEORY

10. Interaction between Demand and Supply Curves of Capital
▪TheequilibriumrateofinterestORisdeterminedatthat
pointwherethedemandforcapital(investment)equalsthe
supplyofcapital(Saving).
▪Demandcurveandsupplycurveintersecteachotheratthe
pointE.ORistheequilibriuminterestrate.
▪IftherateofinterestisgreaterthanOR,thesupplyof
capitalwillexceedthedemandforcapitaland
consequentlytherateofinterestwillbeOR1.
▪Ontheotherhand,therateofinterestislowerthanORthe
demandforcapitalwillexceedthesupplyofcapitaland
consequentlyonceagaintheequilibriumrateofinterestof
OR
2willbeattained.
o
Y
X
Demand and Supply of Capital or Savings
Rate of Interest
S>D
A
B1
D2
C
D>S
S
S
D
D
R1
R2
R
N
E
CLASSICAL THEORY

11. CRITICISM OF THE THEORY
The classical theory of rate of interest has been criticized on the basis of the following shortcomings as
discussed below:
✓Fixed Level of Income:
Classical theory assumes that the level of income remains constant. But in actual practice income changes with a
small change in investment. Thus, it is not correct to assume a fixed level of income.
✓Long Run:
Classical theory determines the interest rate through the interaction of demand and supply of capital in the long
run. Therefore, there was an urgent need of a theory which determines rate of interest in the short-run.
✓Full Employment:
This theory assumes that there is full employment of resources in the economy. But, in reality, unemployment or
less than full employment is a general situation. Thus, this theory does not apply to the present world.
✓Savings and Investment:
Classical economists assume that savings and investment are not inter dependent. But actually investment
changes, income also changes which leads to a change in savings. Thus, both are interdependent on each other.

12. LOANABLE FUNDS THEORY
Supply of LOANABLE FUNDS
S+B+DH+DI
(B) Bank credit–above minimum rate of
interest bank credit is interest elastic.
(DI) Disinvestment–occurs due to non
replacement of depreciated machine
(S) Savings-Saving influenced by both
income and rate of interest.
Demand for LOANABLE FUNDS
I+C+H
(I)Investment demand–demand for
money by firms for investment on part of
firms
(C)Consumption–when consumption
increases beyond income, people have to
borrow money
(H)Hoarding-people’s desire to hoard
money with them
(DH) Dishoarding–peoples desire to
invest/spend money rather than saving it

13. LOANABLE FUNDS THEORY
▪Accordingtothis,Interestisthepricepaidfortheuseofloanablefunds.
▪DemandforloanablefundsisinverselyrelatedtotheRateofinterest.
Demand for loanable Funds
Investment:Highertherateofinterestlowerwillbethedemandforloanablefundsfor
investment
Consumption:Therewillbelessdemandforloanablefundsathighrateofinterestonthe
otherhand,demandforloanablefundsismoreatlowrateofinterest
Hoardings:Demandforloanablefundismadebythosepeoplewhowanttohoardit.
Hoardingsignifieskeepingidlecashbalances.Therefore,athigherrateofinterest,
demandforloanablefundswillbelessandatlowrateofinterestitwillbehigh.

14. Supply of loanable Funds
Savings: Private savings, individuals and corporate are the main sources of savings. Higher
the rate of interest ,the greaterwill be inducement to save and vice-versa.
Bank Credits: Bank Credit is also interest elastic. At higher rate of interest bank will lend
more credit.
Dishoarding: When the idle cash balances of the Past become active balances in the
present , and become available for investment, it is called dishoarding. If the rate of
interest is low, dishoarding would be negligible . When rate of interest is high ,people lend
the hoarded money and thus dishoard their savings.
Disinvestment: The amount which is kept apart annually as depreciation fund, is given on
loan. Higher the rate of interest , greater is the inducement to disinvest and lower the rate
of interest , lesser is the inducement to disinvest.
LOANABLE FUNDS THEORY

15. Rate of interest is
determined at that
point where demand
for and supply of
loanable funds are
equal. i.e. equilibrium
interest rate
DETERMINATION OF RATE OF INTEREST
LOANABLE FUNDS THEORY

16. ✓Saving are not Influenced by Rate of Interest-The theory gives undue importance to
rate of interest on savings .According to this theory, saving is the function of rate of
interest
✓Investment is not Influenced by the Rate of interest-Keynes refuses the relationship
between the rate of interest and investment as postulated by the theory
✓Wrong Synthesis of Real and Monetary Factors-The theory was criticized for
combining Monetary factors with real factors
✓Unrealistic Assumption of full Employment: This theory also assumes full
employment, which is not correct
CRITICISM OF THE THEORY

17. Thank you…..