Interest Theory

Interest TheoryClassical TheoryAccording to the classical theory of interest rate is determined by two factors:- demand for capital- supply of capitalThe capital factors considered are like goods and services, where price is determined by demand and supply

Classical TheoryDemand 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) = QY= Price (cash prices) the interest rate = PD= Demand For Capital = Investments = IClassical TheoryWhile the supply of capital from the people who offer money to be used as capitalS = Supply of capital = the amount of saving (S)

Classical TheoryClassical 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 TheoryIn the opinion of neo classical, Saving markets do not exist, 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 lentNeo Classical TheoryDemand for loan-able funds comes from:The desire to invest in both government and private sectors.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.The creation of new money both currency and demand deposits.Enabling idle money.Thus according to the neo classical balance between demand and supply that determine the level of current interest

Description:I = demand for investment

S = supply on investment

L = demand for loan-able funds to hoarding

M = the supply of loan-able funds, 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, L) with (S, M) is a level interest according to the classical theory is i1)L and M is a given that is in addition to the classical neo-classical theory. The combination of (L, M) with (S, I) creates a new equilibrium at point C which lies lower than the interest rate according to the classical (I3)Modern TheoryInterest theories of John Maynard Keynes is known as the monetary theory of interest and the money supplyAccording to the classical model, increase in the money supply will increase aggregate demand for goods and services directly. Keynes argued that classical economists overstated the impact of the money supply on the economy. He argued that money is one of assets that households keep. A change in the money supply disturbs their equilibrium and therefore they have to re-allocate their assets, including money holdings. This means demand for money must depend on the rate of interestModern TheoryThe desire to hold money due to or driven by three reasons or motives, namely:Transaction motive:People need to hold cash for various motives day to day transactions i.e. to buy goods and servicesPrecautionary motive:This motive refers to the desire to hold money to meet the emergencies and unforeseen expenditures e.g. illness, accidents, unemployment and to face uncertain needs in businessSpeculative motives:They refer to desire of people to keep assets in liquid form to get advantage of the changes in prices of bonds, securities, etc. in the stock exchange marketModern TheoryIn a further discussion Keynes argued that the three motives mentioned above can basically be grouped into two main motives, namely:Transaction motiveSpeculative motives

The Transaction Motive for Liquidity PreferenceThe size of the money that is held depends on the level of income. When income increases, the money held for transactions is also increasingSo the transaction motive for liquidity preference (Lt) is a function of income (Y).

Lt slope depends on factors such as:- Spending habits- The price level- Actions or monetary policyLiquidity for Speculative MotiveIf the interest rate is high then people's desire to hold money for speculative purposes will be reducedSo the speculative motive (LL) is a function of interest (i)

Modern TheoryKeynes further explained that the money in circulation is divided into two parts, namely active money (M1) and speculative money (M2)

Y = incomei = interest rateLt = the transaction motives

LL = speculation motivesM1 = active moneyM2 = speculative moneyRelationship between the Money and Goods MarketsISLM AnalysisSir John Hicks (1904 1989)

Injections, WithdrawalsOI1S1Rate of interestOr1Assume that an interestrate of r1 gives investmentof I1 and saving of S1 Goods market equilibrium: deriving the IS curve18Injections, WithdrawalsOI1S1Assume that an interestrate of r1 gives investmentof I1 and saving of S1 Y1Rate of interestOr1Goods market equilibrium: deriving the IS curve19Injections, WithdrawalsRate of interestOOr1I1S1Assume that an interestrate of r1 gives investmentof I1 and saving of S1 Y1Y1Goods market equilibrium: deriving the IS curve20Injections, WithdrawalsRate of interestOOr1I1S1Assume that an interestrate of r1 gives investmentof I1 and saving of S1 Y1Y1aGoods market equilibrium: deriving the IS curve21Injections, WithdrawalsRate of interestOOr1I1S1Now assume that the interestrate falls to r2, givinginvestment of I2 and saving of S2 Y1Y1I2S2Y2r2aGoods market equilibrium: deriving the IS curve22Injections, WithdrawalsRate of interestOOr1I1S1Now assume that the interestrate falls to r2, givinginvestment of I2 and saving of S2 Y1Y1I2S2 Y2r2aGoods market equilibrium: deriving the IS curve23Injections, WithdrawalsRate of interestOOr1I1S1Y1Y1I2S2Y2r2abNow assume that the interestrate falls to r2, givinginvestment of I2 and saving of S2 Goods market equilibrium: deriving the IS curve24Injections, WithdrawalsRate of interestOOr1I1S1Now assume that the interestrate falls to r2, givinginvestment of I2 and saving of S2 Y1Y1I2S2Y2r2ISbaGoods market equilibrium: deriving the IS curve25The IS curveInjections, WithdrawalsRate of interestOOr1I1S1Y1Y1I2S2 Y2r2ISba26OORate of interestRate of interestMoneyNational incomeY1L'Assume that at a level ofnational income, Y1,the demand for money is L'Money market equilibrium: deriving the LM curve27OORate of interestRate of interestMoneyNational incomeY1MSL'Assume that at a level ofnational income, Y1,the demand for money is L'Money market equilibrium: deriving the LM curve28OORate of interestRate of interestMoneyNational incomeY1MSr1r1L'Assume that at a level ofnational income, Y1,the demand for money is L'Money market equilibrium: deriving the LM curve29OORate of interestRate of interestMoneyNational incomeY1MSr1r1L'cAssume that at a level ofnational income, Y1,the demand for money is L'Money market equilibrium: deriving the LM curve30OORate of interestRate of interestMoneyNational incomeY1MSr1r1Y2L"L'cNow assume that at the higher level of national income, Y2,the demand for money rises to L"Money market equilibrium: deriving the LM curve31OORate of interestRate of interestMoneyNational incomeY1MSr1r1r2r2Y2L"L'cNow assume that at the higher level of national income, Y2,the demand for money rises to L"Money market equilibrium: deriving the LM curve32OORate of interestRate of interestMoneyNational incomeY1MSr1r1r2r2Y2L"L'cdNow assume that at the higher level of national income, Y2,the demand for money rises to L"Money market equilibrium: deriving the LM curve33OORate of interestRate of interestMoneyNational incomeY1LMMSr1r1r2r2Y2L"L'cdNow assume that at the higher level of national income, Y2,the demand for money rises to L"Money market equilibrium: deriving the LM curve34ORate of interestNational incomeLMISEquilibrium in both the goods and money markets35ORate of interestNational incomeISY1aAssume that national incomeis currently at a level of Y1LMEquilibrium in both the goods and money markets36ORate of interestNational incomeISr1Y1aThis gives a rate ofinterest of r1 (point a)LMEquilibrium in both the goods and money markets37ORate of interestNational incomeISr1Y1Y2aBut at r1, national incomeis below the goods marketequilibrium level (Y2)bLMEquilibrium in both the goods and money markets38But as income rises, so therewill be a movement up theLM curve. The interest ratewill rise, thereby reducingnational income below Y2.ORate of interestNational incomeISr1Y1Y2abLMEquilibrium in both the goods and money markets39ORate of interestNational incomeISreYeLMEquilibrium in both the goods and money markets40ORate of interestNational incomeLMISr1Y1ISLM analysis of changes in the goods and money markets41ORate of interestNational incomeIS1r1Y1IS2r2Y2A rise ininjectionsLMISLM analysis of changes in the goods and money markets42ORate of interestNational incomeLM1ISr1Y1LM2r3Y3A rise in themoney supplyISLM analysis of changes in the goods and money markets43LM2LM1ORate of interestNational incomeIS1r1Y1IS2Y4A rise in bothinjections andmoney supplyISLM analysis of changes in the goods and money markets44