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Interest Theory

Classical Theory
• According to the classical theory of
interest rate is determined by two
factors:
- demand for capital
- supply of capital
• The capital factors considered are
like goods and services, where price
is determined by demand and supply

Classical Theory
• Demand for
capital arises
because of the
desire of some
members of the
public to invest
in a business or
buy a stock,
and therefore
the demand for
money arises

X= Quantity (amount of money) = Q
Y = Price (cash prices) the interest
rate = P
D= Demand For Capital =
Investments = I

Classical Theory
• While the supply
of capital from
the people who
offer money to
be used as
capital
• S = Supply of
capital = the
amount of saving
(S)

Classical Theory • Classical theory states that the level of interest rates will be determined by the intersection between the investment and saving curves. . • They assume that the desire to invest as demand for capital while saving as will supply the capital.

Neo – Classical Theory • In the opinion of neo classical. and therefore the price of saving would not be there. • According to the neo-classical theory that there is a market of credit so that the interest rate is the price of credit will be determined by demand and supply of credit. • Loan-able funds (credit fund) itself is intentionally provided funds to be lent . Saving markets do not exist.

Neo – Classical Theory • Demand for loan-able funds comes from: – The desire to invest in both government and private sectors. • Thus according to the neo classical balance between demand and supply that determine the level of current interest . – The creation of new money both currency and demand deposits. – The desire to hold wealth in the form of money (hoarding) • Offerings of loan-able funds comes from: – The desire of some members of the community to save money which is then offered to the capital. – Enabling idle money.

which consist of creation of new money and enable the idle money A = balance is achieved by the L and M B = balance achieved by the I and S (where I3 is the interest in the classics) C = The balance between (I. The combination of (L.Description: I = demand for investment S = supply on investment L = demand for loan-able funds to hoarding M = the supply of loan-able funds. M) with (S. L) with (S. M) is a level interest according to the L and M is a given that is in addition to the classical neoclassical theory. I) creates a new equilibrium at point C which lies lower than the interest rate according to .

• Keynes argued that classical economists overstated the impact of the money supply on the economy. • This means demand for money must depend on the rate of interest . including money holdings. increase in the money supply will increase aggregate demand for goods and services directly. He argued that money is one of assets that households keep.Modern Theory • Interest theories of John Maynard Keynes is known as the monetary theory of interest and the money supply • According to the classical model. • A change in the money supply disturbs their equilibrium and therefore they have to re-allocate their assets.

Modern Theory • The desire to hold money due to or driven by three reasons or motives. securities. illness. namely: – Transaction motive: People need to hold cash for various motives day to day transactions i. unemployment and to face uncertain needs in business – Speculative motives: They refer to desire of people to keep assets in liquid form to get advantage of the changes in prices of bonds.g. etc. accidents. in the stock exchange market .e. to buy goods and services – Precautionary motive: This motive refers to the desire to hold money to meet the emergencies and unforeseen expenditures e.

namely: – Transaction motive – Speculative motives .Modern Theory • In a further discussion Keynes argued that the three motives mentioned above can basically be grouped into two main motives.

The Transaction Motive for Liquidity Preference • The size of the money that is held depends on the level of income. • When income increases.The price level . Lt slope depends on factors such as: .Spending habits . the money held for transactions is also increasing • So the transaction motive for liquidity preference (Lt) is a function of income (Y).Actions or monetary policy .

Liquidity for Speculative Motive • If the interest rate is high then people's desire to hold money for speculative purposes will be reduced • So the speculative motive (LL) is a function of interest (i) .

namely active money (M1) and speculative money (M2) .Modern Theory • Keynes further explained that the money in circulation is divided into two parts.

• • • Y = income i = interest rate Lt = the transaction motives • • • LL = speculation motives M1 = active money M2 = speculative money .

Relationship between the Money and Goods Markets ISLM Analysis .

Sir John Hicks (1904 – 1989) .

Injections. Withdrawals Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 Rate of interest O r1 O I1 .

Injections. Withdrawals Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 Rate of interest O r1 O I1 Y1 .

Withdrawals Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 Rate of interest O I1 Y1 r1 O Y1 .Injections.

Withdrawals Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 Rate of interest O I1 Y1 a r1 O Y1 .Injections.

Injections. giving investment of I2 and saving of S2 S1 S2 Rate of interest O I2 I1 Y1 a r1 r2 O Y2 Y1 . Withdrawals Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2.

Withdrawals Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2.Injections. giving investment of I2 and saving of S2 S1 S2 Rate of interest O I2 I1 Y1 a r1 r2 O Y2 Y1 .

giving investment of I2 and saving of S2 S1 S2 Rate of interest O I2 I1 Y1 a r1 b r2 O Y2 Y1 .Injections. Withdrawals Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2.

Withdrawals Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2. giving investment of I2 and saving of S2 S1 S2 Rate of interest O I2 I1 Y1 Y2 a r1 b r2 IS O Y1 .Injections.

Withdrawals The IS curve S1 S2 O O I2 I1 Y1 r1 r2 Y1 Y2 a b IS .Rate of interest Injections.

Money market equilibrium: deriving the LM curve L' O Rate of interest Rate of interest Assume that at a level of national income. the demand for money is L' O Money Y1 National income . Y1.

Money market equilibrium: deriving the LM curve Assume that at a level of national income. the demand for money is L' L' O Rate of interest Rate of interest MS O Money Y1 National income . Y1.

Money market equilibrium: deriving the LM curve Assume that at a level of national income. Y1. the demand for money is L' r1 L' O Rate of interest Rate of interest MS r1 O Money Y1 National income .

the demand for money is L' r1 L' O Rate of interest Rate of interest MS r1 O Money c Y1 National income .Money market equilibrium: deriving the LM curve Assume that at a level of national income. Y1.

Y2. the demand for money rises to L" r1 L" L' O Rate of interest Rate of interest MS r1 O Money c Y2 Y1 National income .Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income.

the demand for money rises to L" r2 Rate of interest Rate of interest MS r2 r1 L" L' O r1 O Money c Y2 Y1 National income . Y2.Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income.

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income. Y2. the demand for money rises to L" r2 Rate of interest Rate of interest MS d r2 r1 L" L' O r1 O Money c Y2 Y1 National income .

the demand for money rises to L" LM r2 Rate of interest Rate of interest MS d r2 r1 L" L' O r1 O Money c Y2 Y1 National income . Y2.Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income.

Equilibrium in both the goods and money markets Rate of interest LM IS O National income .

Equilibrium in both the goods and money markets LM Rate of interest Assume that national income is currently at a level of Y1 a IS O Y1 National income .

Equilibrium in both the goods and money markets LM Rate of interest This gives a rate of interest of r1 (point a) r1 a IS O Y1 National income .

national income is below the goods market equilibrium level (Y2) r1 a b IS O Y1 Y2 National income .Equilibrium in both the goods and money markets LM Rate of interest But at r1.

Equilibrium in both the goods and money markets LM Rate of interest But as income rises. r1 a b IS O Y1 Y2 National income . so there will be a movement up the LM curve. thereby reducing national income below Y2. The interest rate will rise.

Equilibrium in both the goods and money markets Rate of interest LM re IS O Ye National income .

ISLM analysis of changes in the goods and money markets Rate of interest LM r1 IS O Y1 National income .

ISLM analysis of changes in the goods and money markets LM Rate of interest A rise in injections r2 r1 IS2 IS1 O Y1 Y2 National income .

ISLM analysis of changes in the goods and money markets LM1 LM2 Rate of interest A rise in the money supply r1 r3 IS O Y1 Y3 National income .

ISLM analysis of changes in the goods and money markets LM1 Rate of interest A rise in both injections and money supply LM2 r1 IS2 IS1 O Y1 National income Y4 .