Unit – 4 : Theories of Interest
1) Interest is a payment made by a borrower for the use of a sum of money for a period of time.
2) Three elements can be distinguished in interest:
- Payment for the risk involved in making the loan
- Payment for the trouble involved
- Pure interest, i.e. a payment for the use of money.
3) J M Keynes in his book “The General Theory of Employment, Interest and Money” views that the rate of interest is purely monetary phenomenon and is determined by Demand for money and supply of money.
4) J M Keynes theory is known as “Liquidity Preference Theory”
5) Rate of interest and bond prices are inversely related.
6) Money Demand curve follows from above that quantity of money demanded increases with the fall in the rate of interest or with the increase in level of nominal income.
7) The rate of interest is determined by demand for money (Liquidity Preference) and supply of money – JM Kenes.
8) The position of money demand curve depends upon two factors: 1) The level of nominal income and 2) the expectation about the changes in bond prices in the future which implies change in rate of interest in future.
9) IS and LM curves Theory promulgated by Sir Hon Richard Hicks and Alvin Hansen.
10) The IS curve and the LM curve relate the two variables a) Income and b) the rate of interest. The intersection point of the two curves is the equilibrium rate of interest.
11) LM= Liquidity preference and Money supply equilibrium. LM curve is derived from Kenes Liquidity preference theory of interest.
12) IS = Classical Theory