Prof 7- Chapter 6

Interest Rate Theories

1. Classical Theory/Fisher Hypothesis

2. Loanable Funds Theory

3. Liquidity Preference Theory

4. Rational Expectations Theory

1. Classical Theory/Fisher Hypothesis

One of the oldest theories developed during eighteenth and nineteenth centuries by a number
of British Economist refined by Austrian economist Bohm-Bawerk, and elaborated by Irving Fisher early
in the twentieth century (Rose 1994). It is therefore alternatively referred to as the Fisher hypothesis
(Thomas 1997).

The theory posits that the rate of interest is determined by 2 factors:

1. Supply of Saving

2. Demand for investment capital

More about classical theory:

 This theory highlights the importance of households and businesses.

 Households having more income tend to save more as compared with those with lower
incomes.
 Classical theory assumes that individuals have a difinite time preference for current over future
consumption.
 The interest earned on current savings will give households more to spend in the future. This
will drive the households to save now for future. This is the so called “substitution effect”, that
is, substituting savings now for more consumption in the future.
 Businesses save in the form of investments in financial securities purchased from financial
markets while corporations retain their profits in the form of retained earnings, which they use
for their current operating and capital expenditures.
 Business savings are determined by the profits of corporations and their dividend policies.
 Governments also save although less frequently than households and businesses. Governments
only save when receipts exceed current consumption.
2. Loanable Funds Theory

 A theory that is often used for forecasting interest rates.

 This theory is based on the premise that the interest rate is the price paid for the right to borrow
or use loanable funds.
 Households, businesses, and governments are all both borrowers and lenders at one time or
another.
 Households invest whatever savings they have from their incomes. They also borrow when their
incomes are insufficient to support their needs, especially for unforeseen events such as death
and calamities.
 Business are active participants in the financial markets borrowing from the market for
inventories; working capital needs; purchase of property, plant, and equipment; and other
projects by issuing stocks and bonds.
 Governments borrow from the financial markets by issuing government securities like T-bills, T-
notes, and T-bonds when they have deficits. Governments also buy financial securities from
 financial markets whenever they have surplus funds.

A stable equilibrium interest rate will be characterized by the following:

1. Planned Saving= Planned investment across the whole economic system

2. Money Supply= Money Demand

3. Quantity of loanable funds supplied= quantity of loanable funds demanded

4. The difference between foreign demand for loanable funds and the volume of loanable funds
supplied by foreigners to the domestic economy= the difference between current exports from and
imports into the domestic economy.

3. Liquidity Preference Theory

 In 1930, John Maynard Keynes introduced the concept of money demand and used the term
“liquidity preference” for money demand, this is the reason this theory is called liquidity
preference theory.
  This theory stipulates that the interest rate is determined in the money market by the money
demand and the money supply. Interest rate is the point where the money demand is equal to
money supply.
 like the other theories, this theory also has its limitations. It is a short-term approach to interest
rate determination. In longer- term, interest rates are affected by changes in the level of income
and inflationary expectations.

4. Rational Expectations Theory

 Rational expectations theory came about in the advent of the information age.
 It is based on the premise that the financial markets are highly efficient institutions in digesting
new information affecting interest rates and security prices.
 In contrast to adoptive expectations, which is backward-looking, relying on the past data or
experience, rational expectations, introduced by Lucas in 1973 (Thomas 1997), is forward
looking and uses all available information in forming expectations. This means that households
and firms are forward looking.

Rose (1994) explained the theory:

The rational expectations theory views that forecasting interest rates requires knowledge of the
public’s current set of expectations. If new information is sufficient to alter those expectation,
interest rates must change. If correct, this portion of the rational expectation theory creates
significant problems for government policymakers.