Alternative Theories of Interest

Introduction

• Interest has been defined and interpreted in different ways, but economists commonly regard it as the rate of return on capital.

• Classical economists distinguished between:

  • Natural (real) rate of interest: the rate of return earned on capital investment.

  • Market rate of interest: the rate at which funds can be borrowed in the market.

• When the natural rate of interest exceeds the market rate, investment in capital becomes more attractive, leading to greater capital formation. Increased investment causes the natural rate of return on capital to fall until equilibrium is reached when the natural rate equals the market rate.

• Since physical capital must be purchased using monetary funds, the rate of interest also becomes the rate of return on money invested in physical capital.

• Because the funds used for investment originate from savings, interest is also viewed as the return on savings. This gives rise to two closely related concepts of interest:

  • Interest as the rate of return on capital as a factor of production.

  • Interest as the price paid by borrowers to lenders for the use of savings funds.

• The significance of these concepts depends on perspective:

  • For entrepreneurs and businessmen borrowing funds for investment, the rate of return on physical capital is crucial.

  • For lenders and savers, interest is important as the price received for lending their funds.

• Owing to its relevance to lenders and borrowers, interest is generally defined as the price paid for the use of borrowed funds.

• A distinction must be made between nominal interest rate and real interest rate:

  • Nominal interest rate is the observed market rate of interest.

  • Real interest rate adjusts the nominal rate for inflation.

  Real Rate of Interest = Nominal Rate of Interest − Rate of Inflation.

• The analysis of interest generally focuses on the real rate of interest, since it reflects the actual return after accounting for changes in the general price level.

• Three major theories have been developed to explain the determination of the rate of interest:

  • Classical Theory of Interest.

  • Loanable Funds (Neo-Classical) Theory of Interest.

  • Keynesian Liquidity Preference Theory of Interest.

• The Classical Theory of Interest explains interest as being determined by the interaction of saving and investment.

• The Loanable Funds Theory, developed by economists such as Knut Wicksell, Bertil Ohlin, Gottfried Haberler, Dennis Holme Robertson, and Jacob Viner, incorporates both monetary and non-monetary forces in interest determination.

• Under the Loanable Funds Theory:

  • Interest is determined by the equilibrium between demand for and supply of loanable funds.

  • Loanable funds include not only savings but also funds obtained from other sources.

  • The theory is therefore partly monetary and partly real in nature.

• The publication of John Maynard Keynes’s General Theory gave prominence to the monetary theory of interest.

• According to Keynes:

  • Interest is a purely monetary phenomenon.

  • It is determined by the interaction of demand for money (liquidity preference) and supply of money.

  • Interest is not the reward for waiting, saving, or time preference, but the reward for parting with liquidity.

• Because Keynes emphasized liquidity preference as the key determinant of interest, his explanation is known as the Liquidity Preference Theory of Interest.

• Despite their differences, all three theories explain interest through the interaction of demand and supply forces. The fundamental difference among them lies in identifying what is demanded and what is supplied.

• According to the:

  • Classical Theory: interest is determined by demand for savings for investment and the supply of savings.

  • Loanable Funds Theory: interest is determined by demand for and supply of loanable funds.

  • Keynesian Theory: interest is determined by demand for and supply of money.

• Any satisfactory theory of interest must explain two issues:

  • Why interest arises.

  • How the rate of interest is determined.

• The Classical, Loanable Funds, and Keynesian theories all attempt to explain both the origin of interest and the determination of its rate.

Classical Theory of Interest

• Classical (Real) Theory of Interest explains the determination of the rate of interest through the interaction of demand for savings for investment and supply of savings; it is called a real theory because it is based on real forces such as thrift, time preference, and productivity of capital.

• Classical economists differed regarding the main determinant of interest:

  • Some emphasized the supply side of savings, viewing interest as a reward for abstinence, waiting, or time preference.

  • Others, such as J.B. Clark and F.H. Knight, stressed the marginal productivity of capital, a force operating on the demand side of savings.

  • Irving Fisher and Eugen von Böhm-Bawerk combined both supply-side and demand-side factors in their explanations.

• A fundamental assumption common to all classical writers is full employment of resources:

  • If more resources are devoted to investment (capital goods production), resources must be withdrawn from the production of consumer goods.

  • Money lent to entrepreneurs for investment originates from savings out of income.

  • By reducing current consumption, savers release resources for capital formation.

  • Since saving involves sacrifice, individuals must be offered interest as a reward.

  • A higher rate of interest is required to induce greater saving.

• Nassau Senior’s Abstinence Theory:

  • Saving involves the sacrifice of abstinence from consumption.

  • A person who saves and lends part of his income refrains from consuming it.

  • Interest is the price paid for this sacrifice of abstinence.

  • Without compensation through interest, individuals would be unwilling to undergo this sacrifice.

• Criticism of Abstinence Theory:

  • Karl Marx argued that rich people, who provide most savings, often save without real sacrifice, since savings are merely what remains after satisfying their consumption desires.

  • To overcome this criticism, Alfred Marshall replaced the concept of abstinence with waiting.

• Marshall’s Waiting Theory:

  • Saving does not mean giving up consumption permanently; it means postponing consumption.

  • The lender must wait until the money is returned.

  • The sacrifice involved is therefore waiting rather than abstinence.

  • Interest is the price paid for this waiting and serves as compensation for postponing consumption.

• Irving Fisher’s Time Preference Theory:

  • Fisher gave primary importance to time preference but also recognized the role of the productivity of capital (which he called the rate of return over cost) in determining interest.

  • Interest exists because people generally prefer present enjoyment of goods to future enjoyment.

  • Individuals are impatient to spend income now; interest compensates them for postponing present consumption.

  • The stronger the preference for present consumption, the higher the interest rate required to induce lending and saving.

• Fisher identified several determinants of the degree of impatience (time preference):

  • Size of income:

    • Individuals with large incomes usually satisfy present wants more fully.

    • Their preference for present consumption is lower.

    • They discount the future at a lower rate and require a relatively lower interest rate.

  • Distribution of income over time:

    • If income remains uniform throughout life, impatience depends mainly on income size and temperament.

    • If income is expected to increase with age, the future is better provided for, increasing impatience to consume now and raising time preference.

    • If income is expected to decrease with age, impatience to consume now is lower and time preference declines.

  • Certainty regarding future enjoyment:

    • Greater certainty about future income and enjoyment reduces impatience for present consumption.

    • Time preference becomes smaller.

  • Character and temperament:

    • A far-sighted person has lower impatience and lower time preference.

    • A spendthrift has higher impatience and higher time preference.

  • Expectation of life:

    • Individuals expecting a longer life tend to have a lower preference for immediate consumption and hence a lower time preference.

• Fisher, like Böhm-Bawerk, regarded interest as an agio (premium) on present goods over future goods of the same kind.

• Fisher connected interest with his concept of income and capital value:

  • Interest serves as the link between expected future income values and present capital values.

  • Present capital value is obtained by discounting expected future income streams at the prevailing rate of interest.

  • The value of an asset depends on the future income it is expected to generate; Fisher illustrated this by stating that the value of an orchard depends on the value of its future crops, and the rate of interest is implicitly contained in this valuation process.

• Fisher also incorporated productivity of capital into his theory:

  • Capital can be employed in alternative uses yielding different expected income streams.

  • The greater the expected income stream from a use of capital, the greater the associated rate of interest.

  • He referred to this productive aspect as the rate of return over cost.

• Fisher further introduced risk and uncertainty into interest theory:

  • Individuals choose among various uncertain future income streams.

  • Different investments involve different levels of risk.

  • As a result, there is not a single uniform rate of interest; instead, a variety of interest rates emerges according to the degree of risk involved.