Savings and Investment

Interest
Capital gets reward for its
services which is termed as
Interest. Interest is the reward
for capital.
Before, defining the reward of
capital which is known as
interest. Lets understand what
capital is:
 Capital
Capital is divided into two:

Capital

Fixed Capital Variable Capital

The Whole of fixed as well as variable

capital used for producing anything is
meant capital. But interest is earned
only on the variable capital.
Definition of Interest
According to Seligman, “Interest is the
return from the fund of the capital”.
According to J.M Keynes “Interest is the
reward for parting with liquidity for a
specified period”.
In simple words, Interest is a form of
incentive given by the borrower to the
lender to make him part with his cash
money.
Or it can be defined as “The income
obtained from that part of the capital
which is used for lending. It is the price
paid by the borrower of money to its
lender”.
Gross Interest
It is the amount paid by the borrower to a
lender as a return on capital borrowed.
When we commonly talk of interest, it is
generally gross interest.
Thus, gross interest is a wider term as it
includes in it the following component:
GI= Net Interest + Reward for risk taking +
management + inconvenience.
Time preference theory
 According to this theory people like to
enjoy with money in present period. So to
say, present satisfaction is preferred to
the future satisfaction.
 In this theory we say that rate of interest
is inversely related to the certainty of
income in the future. If the future is
certain, time preference will be less and,
therefore, rate of interest will be low.
 Rate of interest is determined on the basis
of this time preference. A man will change
his income flow by lending or borrowing
until his time preference becomes equal to
the rate of interest.
 Classical Theory Of The Rate Of
Interest

According to the classical theory of interest,

rate of interest is determined by the
interaction of the forces of demand and
supply of capital theory of interest.
Demand for Capital
 Capital is demanded for its productivity. Here it is
said marginal productivity of capital determines
the demand for capital. If marginal productivity of
a capital unit is more, demand for capital will also
be greater and vice versa
 Law of diminishing returns also operates on the
marginal productivity of capital.
 If marginal productivity of capital is more than the
interest paid on it, it will be profitable to borrow
more capital. On the contrary, if the rate of
interest exceeds marginal productivity of capital,
the borrower can reduce his lose or raise his
profits by borrowing less.
Ultimately, equilibrium will prevail on that point
where rate of interest exceeds marginal
productivity of the capital.

Thus, we can conclude that there is an inverse

relationship between the rate of interest and
demand for capital. Demand for capital will be
more on a lower rate of interest and vice
versa.

This can well be made understood with the

graph shown
 D

r
Rate of interest

r1

o m m1

Demand for capital or investment

Supply of Capital
Supply of capital results from savings. In
simple words, the money which is lent is
that portion of income which is not spent
on consumption. So saving is the main
sources of capital. Level of savings depends
mainly upon two things:
(i) Capacity to save (ii) Willingness to save
 S

r1
Rate of Interest

O M M1
Supply of capital or Saving
Determination of the Equilibrium
Rate of Interest

According to classical theory of interest is

determined at the point where the demand for
and supply of capital are equal. In other
words, equilibrium of saving and investment
determines interest rate. This can be
understood through a table
Rate of Demand for Supply of
Interest Capital or capital saving
investment
10% 50 90
9% 60 80
8% 70 70
7% 80 60
6% 90 50
5% 100 40
 D

E1
Q

E
INTEREST

Q1
RATE OF

E2

S D

DEMAND & SUPPLY OF CAPITAL/ SAVING & INTEREST

Criticism of the theory
Based on the assumption of full
employment.
Assumption of long run
Saving and investment equality
Monetary factors ignored
Indeterminate theory
Saving is not the only source of capital
It ignores demand for capital for
unproductive purpose.
Fixed level of income
The Neo-Classical Loanable funds
theory
This theory takes into consideration both
monetary as well as real factors while
determining interest.
According to the theory not only waiting,
time preference, saving and productivity
etc. affect the rate of interest but
monetary factors like hoarding and
dishoarding of money, credit creation
through banks, consumption loans, also
affect the interest rate.
Loanable Funds Theory
So this theory with broad definitions of
demand and supply of loananble funds
determine the rate of interest.
The forces of demand and supply of
loanable funds can be explained.
Demand for loanable funds
The demand for loanable funds arises
mainly from three sources:
 Demand for loanable funds for investment
purposes
 Demand for consumption purposes or
disaving
 Demand for hoarding
Investment Demand
Investment means expenditure of funds on
building new and fresh capital goods. Rate
of interest is the cost of borrowing funds for
investment.
A person will go on borrowing or demanding
money for investment upto the point where
the cost of borrowing i.e rate of interest
becomes equal to its marginal productivity
i.e income earned from its investment.
Thus, there is an inverse
relationship between the
rate of interest and demand
for funds for investment.
Consumption Demand
People also demand loanable funds for
consumption purposes
This relationship is also inverse. In other
words, higher is the rate of interest, lower
the demand for loanable funds for
consumption and vice versa.
Demand for Hoarding
Hoarding means to keep money in idle
cash. It is also interest elastic. At a
higher rate of interest people will like to
hoard less and vice versa.
Thus , in order to derive demand curve
for loanable demand we have to add the
three demand curves i.e Investment
curve, Consumption Curve, Hoarding
Curve and thus, we get a final demand
curve for loanable funds
Supply of Loanable Funds
There are four sources of supply of
loanable funds:
 Savings
 Dishoarding
 Bank money
 disinvestment
Savings
Saving depends mainly upon two things:
 Size of income
 Rate of interest