INTEREST

INTEREST CHARGES

Relevant to inter temporal transactions

Why do interest charges arise?

Calculating Interest Rate
Interest rate
= (Interest charges)/Principal X 100

Interest rate is calculated for a period
of time
Calculating Interest
Calculate the simple interest on Rs.1000
invested on April 1,2013 for 4 years at
the rate of 12% p.a.

Calculate the compound amount on Rs.
1000 invested on April 1,2013 for 4
years at the rate of 12% p.a.
compounded annually.
Transactors
Parties

Postponers Preponers
of Spending of Spending
(Lenders) (Borrowers)
HHs Firms, HHs, Govt.
Postponers of Spending

Primarily the Household Sector

Y > C or S > 0


Preponer of Spending
Firm Sector
New entrepreneurial ventures
Expansion/diversification plans

Interest payments can be made from
the returns generated by the private
investment.






































Preponer of Spending
Household Sector
Investment in new house
Consumer durables

Interest payments can be made due to
an expectation of better future income.
Preponer of Spending
Government Sector
Undertakes developmental expenditure (e.g.
infrastructure, healthcare, education, etc.)
more than current income

Interest payments can be made from the tax
revenues which would be generated from the
employment of resources that ensues
governmental spending



Interaction
Financial Intermediaries

Link postponers of spending and
preponers of spending.
Example
Ram has surplus Rs. 10000, which he is
willing to lend for 2 years.
Manmohan Singh offers him 8% returns
Anil Ambani offers him 15% returns
Johannesburg diamond mining co. offers him
20% returns
Shambhu (the vegetable vendor) offers him
100% returns.
What should Ram do?



Gross Interest Vs. Net Interest

Gross interest
= Net Interest + Risk of Default
PLR and Sub Prime Rates
Prime Lending rate: The rate charged
by commercial banks to their most
secure, creditworthy customers, in the
short run. Acts as a benchmark for
lending to firms and HHs.
Sub Prime Lending rate: Higher than
the PLR. Meant for lending to less than
ideal customers.
Nominal Vs. Real Interest

Nominal Interest
= Real Interest + Expected rate of
inflation

Nominal interest is a.k.a Market interest
DETERMINATION OF
INTEREST
THEORIES
Classical Theory
Savings = f(r)
Savings comprise the primary supply of
money in the market
Investment = g(r)
Investment makes the main demand for
money in the market
Interaction between S and I determines
the market rate of interest


Liquidity preference theory
Lord J.M.Keynes
Interest is the reward for parting with
liquidity for a specified period
Demand for liquidity: transactionary demand,
precautionary demand, speculative demand.
Supply: depends on the money in circulation
in the economy and is determined by the
central bank.
Contd.
Demand: M
t
d
= f (Y)
M
p
d
= f (Y)
M
s
d
= f (r)

Supply: M
s
= M
Equilibrium: Money demand = Money
supply
Neo Classical Theory

A.k.a Loanable funds theory
Interest is determined by demand for and
supply of loanable funds.
Demand: Investment, Consumption,
Hoarding.
Supply: Savings, Bank Credit, Dishoarding.

Equilibrium r.o.i
R.o.i in equilibrium is the level where
the demand and supply of loanable
funds is equal.
If r > r
e
, supply > demand
If r < r
e
, supply < demand

Relationship between bond
price and interest rate
Price of a bond (P)
Face value of a bond (FV)
Interest rate (r)

There exists an inverse relation
between P and r
An Example
If FV of a bond held for 1 year is
Rs.100, r = 5%, then its price, P =
Rs.95.24

If the interest rises to 10%, its price
must fall to Rs. 91
Fiscal Policy and Crowding out
Consider an expansionary fiscal policy:
Increase in G will increase AD and this
will raise output and income.
Higher income will increase M
d
.
If M
s
is held constant, an increase in M
d
will raise interest rates.
This discourages private investment.
Crowding Out

It is the reduction in private demand for
consumption and investment caused by
an increase in the governments
spending, which increases aggregate
demand and interest rates.
Modern Theory of Interest

A.k.a IS LM model

Combines the contribution of the
classical thought and Keynesian
approach


IS Schedule
It shows the different combinations of
income and interest rates at which the
goods market is in equilibrium.

Derivation of IS curve

LM Schedule
It shows the different combinations of
interest rates and income compatible
with the equilibrium in the money
market.

Derivation of LM curve.
Determination of interest rate
Equilibrium in the goods and the money
market: Intersection of IS and LM
If r > r
e
, income is too low for money
market equil.,M
d
< M
s
, this causes r to
fall
If r < r
e
, income is too high for the
money market equil., M
d
> M
s
, this
causes r to rise.
Money market

Interest rates are determined by the
money market equilibrium.

M
s
= M
d



Product market
Interest rates influence the level of
private investment which in turn
influences the level of income and
output.
AD = C + I
Since Y = AD, Y = C + I