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Theories of Interest Rates Determination

# Theories of Interest Rates Determination

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02/13/2014

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THEORIES OF INTEREST RATES DETERMINATION
Interest rates, refers to payment, normally expressed as a percentage of the sum lent which is paidover a year, for the loan of money. There are many rates of interest depending on the
degree or riskinvolved, the term of the loan
, and the
namely, real, nominal and purerate of interest.Pure rate of interest is one from which factors like
risk involved
, the
term of the loan
and the
has been removed. All rates of interest are related to each other and if one ratechanges so will others.There are two theories as to how the rate of interest is determined – the
loanable funds
and
theliquidity preference
theories.
a. The Loanable Funds Theory
Also called the classical theory of interest, was developed at the time of classical economists likeAdam Smith, David Ricardo and Thomas Malthus, who held the view that economic activities wereguided by some kind of invisible hand i.e. through the self interest motive and the price mechanism,and that Government interference was unnecessary and should be kept at minimum.SSssThey therefore explained the rate of interest in terms of the
demand
for money and
supply ofloanable funds.
The demand comes from firms wishing to invest. The lower the rate of interestthe larger the number of projects which will be profitable. Thus, the demand curve for funds willslope downwards from left to right.The supply of loanable funds comes from savings. If people are to save they will require a reward-interest – to compensate them for forgoing present consumption. If the interest rate is high, peoplewill be encouraged to save and lend. If the interest rate is low, people will be discouraged fromsaving and lending. Hence, the supply curve of loanable funds slopes upwards.

Interest SRate %SLoanable Funds

2
The market rate of interest is therefore determined where the demand for and supply of
loanablefunds
are equal. Geometrically this corresponds to the point of intersection between the supplycurve and the demand curve for loanable funds.DSInterest Rate%IDSL Loanable Fundsi is the equilibrium market rate of interest and L the equilibrium level of
loanable
funds. Above i,there is excess of supply over demand, and interest rates will be forced downwards. Below i there isexcess of demand over supply and interest rates will be forced upwards.Changes in demand or supply will cause shifts in the relevant curves and changes in the equilibriumrate of interest.Although this theory has a certain amount of
validity,
it has been criticized on the followinggrounds:i. It assumes that money is borrowed entirely for the purchase of capital assets. This is not truebecause money can be borrowed for the purchase of consumer goods (e.g. cars or houses)InterestRate % SSLoanable Funds

3
ii. It assumes that the decision to borrow and invest depends entirely on interest. This is not thecase, for business expectations play more important role in the decision to invest. Thus ifbusiness expectations are high, investors will borrow and invest, even if the rate of interest ishigh and if business expectations are low investors will not borrow and invest even if the rate ofinterest is low.iii. It assumes that the decision to save depends entirely on the rate of interest. This is not true forpeople can save for purposes other than earning interest, e.g. as precaution against expectedfuture events like illness or in order to meet a certain target (this is called target savings) orsimply out of habit.
b. The Keynesian Theory
Also called the
Monetary Theory of Interest
, was put forward by the Lord John MaynardKeynes in 1936. In the theory, he stated that the rate of interest is determined by the supply ofmoney and the desire to hold money. He thus viewed money as a liquid asset, interest being thepayment for the loss of that liquidity.Keynes formulated derived from three motives for holding money, namely:

Transactions;

Precautionary; and

Speculative.Thus Keynes contended that an individuals aggregate demand for money in any given period will bethe result of a single decision that would be a composite of those three motives.
a. Transactions demand for money
Keynes argued that holding money is a cost and the cost is equal to the interest rate foregone.People holding money as assets could also buy Government bonds to earn interest. But moneysmost important function is as medium of exchange. Consumers need money to purchase goods andservices and firms need money to purchase raw materials and hire factor services. People thereforehold money because income and expenditure do not perfectly synchronize in time. People receiveincome either on monthly, weekly, or yearly basis but spend daily, therefore money is needed tobridge the time interval between
receipt of income
and its
disbursement over time
.The amount of money that consumers need for transactions will depend on their
spending habits,time interval after which income is received
and
Income.
Therefore holding habit and IntervalConstant, the higher the income level the more the money you hold for transactions. Keynes thusconcluded that transactionsdemand for money is Interest Inelastic.