Note on Interest

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source:slidemodel.com
source: slidemodel.com

Interest is the reward for the capital. It is defined as the payment made by a borrower to a money lender for the use of production capacity of capital. Interest is the charge for the privilege of borrowing money.

According to Carve, “Interest is the income which goes to the owner of the capital.”

According to Seligman, “Interest is the return from the fund of capital.”

According to J. M. Keynes, “Interest is a reward for parting with liquidity for specified period.”

Money is a liquid asset which can be used for any purpose at any time. Interest is the price paid for the use of money in credit. The neo-classical economists nevertheless define it as the price for the use of loanable funds. But the modern economists explain it in terms of the demand and supply of money.

Interest can be divided into two types:

  1. Gross Interest

Total amount paid to the lender by the borrower is known as gross interest. Total amount includes the following:

  • Reward for Risk Taking: While lending the money the lender also takes a risk with his money. So, the lender charges some price of the risk as interest. Interest depends on the risk.

  • Reward for Management: The lender has to manage the account of his lending. While collecting the amount lender have to spend on the account, stationery, etc. The lender has to go to the borrower time to time. Thus, the extra expenses are incurred in the gross interest.

  • Reward for Inconveniences: When a lender loans money, his money is locked up and cannot be used for more profitable purposes. In gross interest rates, the lender includes in it the reward for such inconveniences.
  1. Net Interest

It is the payment for the use of capital or money only excluding any other charges. It is known as pure interest. If we subtract the reward for risk taking, reward for management and reward for the inconvenience from the gross interest we get net interest. Thus,

Net interest = Gross interest – (reward for risk taking + reward for management + reward for the inconvenience).

Classical Theory of Interest

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This theory of interest is developed by classical economists and it is also known as demand and supply theory of interest. This theory states that interest is determined by the interaction of demand for and supply of capital.

According to the classical theory of interest,it is the payment paid for saving the capital. Any price is determined by demand and supply. In this case, demand means demand for investment and supply means the supply of saving. Let us consider the demand and supply sides separately.

Rate of Interest

Demand for Capital

Supply of Capital

Remark

2

100

20

Disequilibrium

4

80

40

Disequilibrium

6

60

60

Equilibrium

8

40

80

Disequilibrium

10

20

100

Disequilibrium

From the above table, as the rate of interest increases from 1 to 2, the demand for capital decreases from 100 to 80. And the supply capital goes on increasing from 20 to 40 with the increase in rate. Similarly, demand goes on decreasing and supply goes increasing with the increases in rate. And at the rate 3, demand for capital is 60 and supply of capital is also 60 which is equilibrium points (D = S)


Demand side

Demand mostly comes from the thought of business because a firm wants to purchase new capital goods. Demand for capital comes from entrepreneurs who wish to invest in productive purposes. In fact, demand for capital implies the demand for savings.

In short, capital is productive because capital has the power to yield an income even after covering its cost i.e. interest. The marginal productivity curve of capital, thus, determines the demand curve for capital. Investment demand expands when the interest rate falls and it contracts when the interest rate rises. Thus, there is an inverse relation between investment and capital.

Supply side

Supply is the source of capital formation which depends basically on the availability of savings in the economy. Savings emerge out of the people's desire and capacity to save. The supply of funds depends on the willingness to save. This willingness is related to the marginal rate of time preference.

According to the classical theory, the money used for purchasing capital goods is made available by those who save from their current income. The more savings the people do, the more consumption they have to postpone. Thus, in order to induce people to save more, a higher rate of interest must be offered.

Criticism of classical theory of interest

  1. Ignores bank money

The classical theory has mainly focused on creating a real saving for the supply of capital. However at present, mostly the capital is generated out of credit creation by the bank and financial than the real saving.

  1. Narrow scope

According to Keynes, this theory has considered the demand for capital only for investment, however, the money is demanded also for consumption and to meet emergencies.

  1. Saving and Investment are not functions of Interest Rate

Keynes also points out that the equality between saving and investment was brought about by changes in the level of income and not by the rate of interest, as asserted by the classical economists.

  1. Indeterminate theory

It has not clearly mentioned whether the interest rate should influence saving and investment or rather investment and saving should influence the interest rate.

  1. Interest is not only the reward for saving

According to Keynes, interest is purely a money phenomenon, a payment for the use of money and that the rate of interest is the reward for parting with liquidity rather than a return on saving.

(Jha, Bhusal, and Bista)(Karna, Khanal, and Chaulagain)

Bibliography

Jha, P.K., et al. Economics II. Kalimati, Kathmandu: Dreamland Publication, 2011.

Karna, Dr.Surendra Labh, Bhawani Prasad Khanal and Neelam Prasad Chaulagain. Economics. Kathmandu: Jupiter Publisher and Distributors Pvt. Ltd, 2070.

  1. Interest is the reward for the capital.
  2. This theory of interest is developed by classical economists and it is also known as demand and supply theory of interest.
  3. Demand mostly comes from the thought of business because a firm wants to purchase new capital goods.

Criticism of classical theory of interest

  1. Ignores bank money
  2. Narrow space
  3. Saving and Investment are not function of Interest Rate
  4. Indeterminate theory
  5. Interest is not only the reward for saving
.

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