BCom 3rd Year Money Financial System Interest Rates Study Material Notes

BCom 3rd Year Money Financial System Interest Rates study Material Notes: Why is Interest Paid Factors Affecting Interest Rates Or Causes of Difference IN Interest Rates  Theories of Interest Classical Theory of  Interest Saving Investment Theory of Interest Loan able Funds Theory or Neo-Classical Theory Modern Theory of Interest  Criticism of the Theory  Can Interest Rate Become Zero Exercise Questions Long Answer Questions Short Answer Questions :

BCom 3rd Year Nature Importance Financial Money Study Material notes in Hindi

INTEREST RATES

The part of the national income that is given to the capitalist in return for the use of the capital is called interest. In fact, the capital is formed through savings and for savings the saving holders have to sacrifice their present needs. So, the interest is the result of this sacrifice. In other words, the return given for the use of monetary capital is called interest.

Interest has been defined by many scholars. Some of the important definitions are as follows:

(1) According to Marshall, “The payment made by the borrower for the use of a loan is called Interest.”

(2) According to Prof. Keynes, “Interest is reward of parting with liquidity for a specified period.”

(3) According to Prof. Seligman, “Interest is the return from fund of capital.”

(4) According to Prof. Wicksell, “Interest may be defined as a payment made by the borrower of capital by virtue of its productivity as a reward for his abstinence.”

(5) According to A. L. Mayers, “Interest is the price for the use of loanable fund.”

(6) According to Carwer, “Interest may be defined as the income which goes to the owner of capital.”

(7) According to Richard, “Interest is primarily a reward for waiting.”

After the study of the above definitions it can be said that the different economists have defined “Interest” differently, but as a conclusion it can be said that” Interest is a reward given to the capitalist as a return for the use of capital and it is related to money.”

Money Financial System Interest

WHY IS INTEREST PAID ?

There are two main view points about paying interest :

(A) In Debtors’ Point of View : Interest is paid by debtors. So according to the debtors’s viewpoint there are following reasons for the payment of interest.

(1) Use of Capital : When somebody gets loan, he uses it in such work out of which he gets both income and satisfactions. It may be that it was not possible in its absence. So, the capitalist is paid capital in return for the use of Capital.

(2) Reward of Risk: Whether a loan is granted for the short term or the long term, the creditor faces a risk by giving loans. It is possible that the loan become a non-refundable loan. Thus, interest is the reward of risk.

(3) Payment for Inconvenience: Loan is given generally for a particular period. In this period, even if the creditor needs money, he can’t get his money back from the debtor. So, in this period the creditor may have to face many economic problems. Thus, interest is a payment for this inconvenience.

(4) Payment for Management: From granting loan to recovering loan a creditor has to meet many managerial expenses. Some examples are salary of accountant, commission to collection agent, purchase of ledger book, legal expenses etc. The creditor wants to recover all these expenses from his debtor. Thus interest is paid for meeting the managerial expenses.

(B) In Creditors’ Point of View : The capacity of granting loans by a creditor depends on his capital formation. He takes interest in capital formation with the view of getting interest. If he doesn’t get interest, he won’t take interest in increasing the tendency of saving for the capital formation.

Money Financial System Interest

FACTORS AFFECTING INTEREST RATES

(OR)

CAUSES OF DIFFERENCE IN INTEREST RATES

Rates of interest vary for individuals, enterprises, places and times. Following are the main causes responsible for these differences:

(1) Difference in Risk: There are some activities which involve high risk and some others have less risk. Speculative business and shares trading involve much risk. So, the rate of interest is very high in this trade. On the contrary, the trades of fixed nature have much support of market and so there is less risk. So, the rate of interest in such trades is comparatively low.

(2) Difference in Period: The rate of interest is high for long term loans. One cause for it is the reduction in monetary value of the loan due to inflation and the nature of loan turning into non-refundable loans. On the contrary, the rate of interest for the short term loans is low because the recovery of the loan is almost guaranteed.

(3) Difference in Security: The rate of interest is low on a loan given on the basis of proper security, while it is high on the loan given on insufficient security or no security. However, the personal credit of the debtor also influences the rate of interest.

(4) Difference in use of Loan : If the loan is used in productive activities the debtor gets income from that loan. Thus, there is not much problem in the recovery of the loan. The rate of interest on such loan is low. On the contrary, if the loan is taken for unproductive activities like construction of building, marriage ceremony etc, the rate of interest is very high because there is chance of nonrecovery of this loan.

(5) Development of Banks: An area where there is much development of banks and there are branches of many banks, there is much competition. Consequently, the rate of interest is low in that area. On the contrary, the areas, where there is not proper development of banks, the demand of credit is high and supply is less. Consequently, the rate of interest is high.

(6) Amount of loan : If the amount of loan is more the rate of interest is low and if the amount of loan is low, the rate of interest is generally high. The important reasons behind this is that loans in higher amount are generally given to people with strong economic condition and strong credit and recovery is generally easy.

(7) Political Situation : The rate of interest depends on the political condition of the country also. If there is peace and order in the country and there is a stable government, the rate of interest is low.

(8) Economic Development: The rate of interest is low in developed countries, because per capita income is high there and the amount of savings is high. More ever, the supply of capital is high in these countries. On the contrary in the undeveloped and developing countries, the demand of loan is higher than its supply. So, the rate of interest is high in these countries.

(9) Situation of Loan Recovery : Where there is easy situation for the recovery of loan, the rate of interest is low. The rate of interest is high where there is trouble in the recovery of loan.

(10) Trade Cycle : When there is the tendency of rise in the economy, the rate of interest is low. Opposite to it, due to the feeling of insecurity during the period of depression, the rate of interest is high.

(11) Population : In case of increase in the population, the demand of loans increases and consequently the rate of interest is high. On the other hand, during the decrease in population, the demand of loans decreases and as a result, the rate of interest is low.

Money Financial System Interest

THEORIES OF INTEREST

The topic of the consideration of interest has been the subject of economics and monetary theory. From the beginning, the subject of determination of interest has been a matter of dispute and debate. Many economists have postulated different principles related to interest.

The Marginal Productivity Concept of Malthus and J. B. Say, the Theory of Sacrifice by Prof. Senior, the Waiting Theory of Interest by Prof. Marshall and the Preference Theory of Interest by John Ray, Bohm Bawerk and Irving Fisher are considered the old principles of interest. Thus, we shall analyse the modern principles of interest here. The main modern concepts of interest are as follows:

(1) The Classical Theory of Interest

(2) Neo-Classical Theory or The Loanable Fund Theory of Interest

(3) The Liquidity Preference Theory of Interest

(4) The Modern Theory of Interest

CLASSICAL THEORY OF INTEREST

(OR)

SAVING INVESTMENT THEORY OF INTEREST

It is also called, the ‘Reputed Theory of Interest.’ The Credit of postulation of this theory doesn’t go  to any particular economist. Marshall, Warras, Prof. Pigou, Knight, Mill etc. are together considered as the postualtors of this theory.

According to this theory, the rate of interest is considered according to the relative power of demand of Capital and supply of Capital. That is why it is also called the ‘Demand Supply Theory of capital and supply of the capital is the determiner of Demand of Capital interest rate, so the separate study of these two is essential.

Demand of Capital : Capital is the Movable Source of production. Its demand is made by producers or entrepreneurs class for investment. In other words, the demands of capital rise due to productivity, so the demand of capital depends on the marginal productivity of capital. A producer will demand capital so long as the marginal productivity of the capital doesn’t get equal to the rate of interest. So, due to decreasing marginal productivity there is a negative relationship between the demand of Captial and the rate of interest. In the figure 1, OX line represents the demand of the capital and OY line represents the rate of interest. When the rate of interest is OR, the demand of the capital is ON. When the rate of interest increases up to OR1, the demand of capital gets reduced to ON1. On the other hand, when the rate of interest reduces to OR2, the demand of the Capital increases up to ON2. In the figure, the curve of the rate of interest and the demand of the capital has been represented by the line DD.

Supply of Money : The supply of Capital is the result of Saving because the Capital formation is due to savings. For savings, people have to make some sacrifice of the present needs. When somebody saves some money, he expects to get some interest as reward. Thus, interest encourages savings. The supply of Capital is from this saving. So, there is a direct relationship between interest and supply of capital. The higher the rate ou of interst, higher is the supply of 5 capital and lower is the rate of E interest, the lower is the supply of 18 R2 Capital. In figuure 2 the curve SS from left to right represent the supply of capital. Its ascend from down to up is the result of this logic. According to the figure, ON is the

supply of the capital at the interest rate OR and when the rate of interest gets reduced to OR2 the supply of the capital becomes ON2. Simarly, when the rate of interest increases to OR1, the supply of the capital also increase to ON1.

Determination of Interest Rate : According to this theory, the rate of interest is determined at that point where its demand and supply equalize each other.

The process of determination of interest is classified in figure 3. In this figure the demand of Capital is represented on the X Axis and he rate of interest if Represented by the

y-axis. The curve DD representating the demand of Capital and the curve SS representating the supply intersect each other at point E. Thus, at the interest rate ORX, there establishes a balance between the demand of capital and its supply.

Money Financial System Interest

CRITICISMS OF THE THEORY

The main criticisms of this theory are as follows:

(1) The incomes of the people have been considered stable in this theory, while in reality the income level of the people fluctuates.

(2) The theory of full employment has been recognised in this theory. But there is never full employment in the society.

(3) The classical economists have considered that there establishes a balance between savings and investments through the rate of interest. But Keynes has said that this balance is credited by the changes in incomes instead of interest rate.

(4) The bank credit has not been given any place in this theory, while it has an important place in the consideration of the interest rate.

(5) The classical economists have considered money to be passive, while in reality, money is active.

(6) According to this theory the interest rate is the cause of savings, while in reality income is the real cause of savings.

(7) According to classical economists the Capital formation is through savings. Thus, in this theory the accumulated Capital has been rejected.

LOANABLE FUNDS THEORY

OR

NEO CLASSICAL THEORY

Swedish economist Wicksell, Ohlin and Mydal are the postulators of the ‘Loanable Funds Theory.’ The English economist Prof. Robertson has also supported this theory. According to this theory, the rate of interest is considered by the demand and supply of loanable funds. In this theory, the accumulation of money, Reserves bank credit and other monetary elements are considered along with productivity, wait, savings and other real elements. In this way this theory is an amendment of the classical theory. The study of demand and supply of loanable fund is essential to clarify this theory.

Demand for Loanable Fund : The demand for loanable fund is mainly made for the following three causes :

(1) Investment: The trading firms demand loanable funds for investments. Loan and interest is paid from the return obtained from this investments. The demand for loanable fund is high when the rate of interest is low and demand of loanable fund is low when the rate of interest is high.

(2) Consumption: There are two kinds of people demanding loanable fundsFirst those whose expenditure is more than their income and the second, those who are extravagant by nature. When the rate of interest is low, the demand for loanable fund for consumption is high. On the contrary when the rate of interest is high, the demand for such funds is low.’

(3) Hoarding : Many people have the tendency of hoarding. Hence, when the rate of interest is low, the demand for loanable fund by people hoarding money is high.

Thus, the total demand of loanable fund = Investment + Consumption + Hoarding

DL = I + C + H

Where, DL = Demand for Loanable Fund

I = Investment

C = Consumption

H = Hoarding

Supply of Loanable Fund: There are four important sources of Loanable funds. These are as follows:

(1) Savings : The difference between income and consumption is savings. This is the most important source of the supply of the Loanable fund. Savings is done by people, trading sector and government. The Savings is more when the interest is high and Savings is low when the rate of interest is low.

(2) Bank Credit Money : The bank credit is the other important source of the supply of Loanable funds. The commercial bank creates credit. The supply of credit by the bank is high at high interest rate and the supply of credit is low at low interest rate.

(3) Disholding : It is the nature of human that they hoard a part of their income in the form of money. When the rate of interst is high, the money hoarded in the past is also disholded and the supply of loanable funds increases.

(4) Disinvestment: Disinvestment means Selling the running industries by industrialist to return the amount or giving in the form of interest, the different funds (for ex-Depreciation Fund) created by the industries. Disinvestment is more if the rate of interest is high and disinvestment is less if the rate of interest is low.

Thus, The supply of Loanable Fund = Savings + Bank Credit + Disholding + Disinvestment

SL = S+M+DH + DI

Where, SL = Supply of Loanable Funds

S = Savings

M = Bank Credit

DH = Disholding

DI = Disinvestment

Determination of Interest: According to this theory, the rate of interest is considered at that point where the demand and supply of loanable fund equalise each other. It has been clarified in fig 4.Thus, in the consideration of interest DL = SL. In the figure the interest rate is considered at point E and the rate of interest is considered equal to OR.


CRITICISM OF THE THEORY

The main criticisms of this theory are as follows:

(1) Prof. Keynes has criticised that in this theory also classical economists have considered the condition of full employment as the basis. This considereation • is totally unrealistic.

(2) The criticisers have considered that in the consideration of interest both the real and monetary elements have been included, whereas these two are different elements.

(3) The critics held that the supply of money in the economy is stable. Thus, there is no change in hoarding by the change in the rate of interest. Even when there is less hoarding with some people and more with some other, there is no effect on the total hoarding.

(4) According to this theory, the rate of interest is considered by the relative force of demand and supply. But It is not visible in practice.

LIQUIDITY PREFERENCE THEORY OF INTEREST

Well known classical economist J.M. Keynes has postulated the Liquidity Preference Theory of Interest. In his book “General Theory of Employment, Interest and Money’ published in 1936, he has written” Interest is a monetary event. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantiy of cash.”

Cash money is the most liquid form of money. For many reasons people want to keep liquid money with them. In other words, people have liquidity preference. So, when somebody gives his liquid money to some other person as loan, he has to sacrifice his liquidity. The reward obtained in return for this sacrifice is called interest rate. According to Keynes, “Interest is the reward for parting with liquidity for a specified period.”

According to Keynes’ theory, the interest is considered by demand and supply. Thus the detailed analysis of the demand and supply of money is essential.

Demand of Money: According to Keynes, “The demand of money refers to that amount which people want to keep with them in the liquid form.” people want to keep liquid money with them for the following reasons

(1) Transaction Motive: Generally, people get income on the daily, weekly, fortnightly, monthly, annually or irregular basis, but expenses have to be done everyday to meet the expenses of daily life. The number of people having daily income is very few. So, those people who don’t have daily income want to keep liquid money with them to meet their expenses. In business sector also people have to keep cash with them to meet revenue expenses.

(2) Precautionary Motive: Nobody knows what is hidden in future. So, people keep liquid money with them to tackle sickness, unemployment, old age and accidental circumstances.

(3) Speculative Motive : Some people do speculative business also. So, there is a need of cash for this. If a trader feels that there will be a rise in the price of raw materials, he would like to stock it. So, there is also the need of liquid money. This way people like to keep liquid money with them with speculative motive also.

Supply of Money : By the term Supply of Money, Keynes refers to currency metal money and credit money. Generally, the rate of interest doesn’t determine the supply of money, because in any country the supply of money is determined

Determination of Interest Rate : According to Keynes, the rate of interest depends on the supply and demand of money.

There is opposite relationship between the rate of interest and the liquidity preference. But the supply 3 of money remains stable due the monetary policy. So, the rate of interest is determined as the rate of interest at which the liquidity preference of money equalises the supply of money. In figure 5, LP is the curve of Liquidity preference of money which expresses the demand of money. SS is the line of Supply of money which shows the stable supply of Demand and Supply of Money money. These two lines intersect

Fig. 5 each other at point E. Thus the rate of interest gets determined at this point. So, at the R percent interest rate SO is the supply of money.

Criticism of the Theory: The main criticism of this theory are as follows:

(1) Keynes has neglected the time factor in the postulation of this theory.

(2) Keynes has also neglected economy, savings, the marginal productivity of money and other non-monetary elements. It doesn’t get clarified that which of real elements are active for the demand and supply of money.

Money Financial System Interest

(3) The demand aspect has been emphasised in this theory while the supply aspect has been marginalised. Thus this theory is biased.

(4) There is close relatinship between income, savings and capital formation. But in postulating this theory Keynes has neglected income and savings.

(5) In the view of critics the theory given by Keynes is proper for shortterm only and not for long-term.

MODERN THEORY OF INTEREST

The economists Prof. Hicks and Prof. Hansen have postulated this theory. That is why it is also called “Hicks-Hansen Co-ordination Theory.”

These economists have considered the theories given by the classical economists and Keynes and have clarified that it has been said in the theories of the reputed economists that the rate of interest is determined at that point where the quantity of savings and investment equalise each other. Thus in the classical theory only real elements like real saving and real investment have been given importance. Similarly in the Keynes theory only monetary elements have been given place.

“The Modern Thoery of Interest’ is the mixture of the classical Theory and the ‘Liquidity Preference Theory of Keynes in reality. Following four elements are obtained by the co-ordination of these two theories.

(1) Investment Demand Function

(2) Saving Function

(3) Liquidity Preference Curve

(4) Supply of Money.

Two curves are obtained by the above four elements.

(1) Investment Saving Curve [IS Curve] : Investment Saving Curve has been taken from the classical theory. It tells about such coincidences of interest and income where savings and investment are equal. According to the classical Ideology.

I= F (r) i.e. Investment is the result of interest rate

S= F (Y) i.e. saving is the result of income.

In figure 6 the derivation of IS Curve has been shown. Yl, Y2, YS, Y4 and Y5 are different levels of income on which the saving curves are SiYi, S2Y2, S3Y3, S4Y4 and S5Y5 respectively. The saving curves establish equality with investment and determine the intermine the interest rates rl, r2, r3, r4 and r5 respectively. Part A of the figure tells that the rates of interest have been shown at different income levels in the condition of equality of savings and investment. In Part B of the figure the relationship in the interest rates at different income levels has been shown.(2) Liquidity Preference line and amount of money curve : [ LM Curvel : Keynes has considered the interest rate a totally monetary event . The LM Curve Derives From the Liquidity Preference Theory of Keynes . LM Curve

tells that if the amount of money and liquidity preference are given then the interest rates for different income levels can be determined. It has been clarified in figure 7. In this figure the liquidity preference curves L1Y1, L2Y2, L3Y3, LAY4 and L5Y5 at different income levels Y1, Y2, Y3, Y4 and Y5 have been shown. These establish equality between the demand and supply of money and determine the rates of interest ri, r2, r3, r4 and r4 respecitively.

Determination of Rate of Interest: The determination of interest rates with the help of IS and LM Curves has been shown in the figure 8. In this figure IS curve and LM curve intersect each other at point P. So, the rate of interest becomes OR at this point. At this coincidence of the rate of interest and income both the conditions of I = S and L = M get fulfilled.

CAN INTEREST RATE BECOME ZERO?

There are two viewpoints whether the rate of interest can become zero or not. A few consider it on practical ground that the rate of interest cannot become zero. In real life, it is not possible that one gets capital without proper attempt and the capital is obtained without any charge. So, the # rate of interest can not become zero. 5 But from the theoretical viewpoints in some cases, the rate of interest can be zero or negative.

The rate of 9 interest can become zero or negative e when people have to pay charge to keep their savings or the total income is consumed and there is no saving. Similarly, in the case of marginal utility of the capital being zero, the M rate of interest will be zero. But it is Income Level not seen in the practical life. Thus, Fig. 8 the rate of interest can never be zero.

Money Financial System Interest

EXERCISE QUESTIONS

Long Answer Type Questions

1 Critically examine the Liquidity Prefernce Theory of Interest.

2. Explain Modern Theory of Interest. Can the rate of interest be zero?

3. Critically explain the Loanable Funds Theory of Interest.

Short AnswerType Questions

1. What do you understand by interest ?

2. What are the reasons of difference in rate of interest ?

3. What is Liquidity Preference ?

4. What is IS Curve ?

5. Can interest rate become Zero ?

6. Why interest is paid ?

Money Financial System Interest

III. Objective Type Questions

Choose the correct option

1. Who said, “Interest is the return from the fund of Capital ?”

(a) Prof. Marshall

(b) Seligman

(c) Mayers

(d) Prof. Wicksell

2. Who gave the statement, “Interest is primarily a reward for waiting”?

(a) Keynes

(b) Karwer

(d) J.B. Say

(c) Richard

3. The cause of difference in the interest rate is/are….

(b) Difference in period

(a) Difference in risk

(d) All of the above

(c) Difference in security

4. The credit of the Classical Theory of interest goes to……….

(a) Marshall

(b) Walras

(c) Pigou

(d) All of the above

5. Keynes famous book “General Theory of Employment, Interest and Money” was published in the year…..

(a) 1936

(b) 1937

(c) 1948

(d) 1953

6. The cause of demand of loanable fund is …

(a) Investment

(b) Consumption

(c) Hoarding

(d) All of the above

7. The source of supply of loanable fund is/are……..

(a) Savings

(b) Bank Credit

(c) Disinvestment

(d) All of the above

8. Which is the other name for the “Modern Theory of Interest” ?

(a) Hicks-Hansen Interest Theory

(b) Liquidity Preference Theory

(c) The Neo-classical Theory of Interest

(d) None of the above

9. In case of insufficient security, the rate of interest is..

(a) Low

(b) High

(c) Average

(d) Zero

10. In the situation of the amount of loan being high, the rate of interest is generally……

(a) Low

(b) High

(c) Very High

(d) Zero

[Ans. 1. (b), 2 (c), 3. (d), 4. (d), 5. (a), 6. (d), 7.(d), 8. (a), 9. (b), 10. (a)]

State whether the following statements are True or False :

1 The father of liquidity preference theory of interest was J.M. Keynes.

2. The part of the national income that is given to the capitalist is called interest.

3. Interest is the reward of risk.

4. The rate of interest can be zero.

[Ans.: 1. True, 2. True, 3. True, 4. False.]

Money Financial System Interest