Theories of Interest

Interest is the price paid for the use of capital -- the reward a borrower pays a lender for the use of funds over time, normally quoted as a percentage rate per year.

Gross interest and net interest. The rate actually charged on a real-world loan -- gross interest -- is not a pure, single payment for capital; it bundles together several components. Net interest is the pure reward for parting with capital, or for "waiting" (giving up one's own present consumption to lend to someone else). On top of net interest, gross interest also includes a premium for the risk that the borrower may default, a premium for the inconvenience and management of arranging and recovering the loan, and, at times, an allowance for expected inflation. Net interest is what would remain on a perfectly safe, hassle-free loan once these extra premiums are stripped away.

Classical (real) theory of interest. The classical economists explained the rate of interest purely through real forces, treating money as no more than a convenient veil over these forces. The supply of capital comes from household saving -- postponing today's consumption, an act of "abstinence" that savers must be compensated for. The demand for capital comes from firms wanting to invest, driven by how productive additional capital is expected to be. Interest is simply the price that brings saving (supply) and investment (demand) into balance in the market for capital.

Loanable funds theory. Neo-classical economists such as Knut Wicksell and Bertil Ohlin widened the classical account by adding monetary factors alongside the real ones. On the supply side, loanable funds come from savings, dishoarding (people releasing money balances they had been holding idle), and fresh bank credit; on the demand side, they are wanted for investment, government borrowing, and hoarding (people wanting to build up idle balances). The interest rate settles where the two sides are equal:

Because it folds in bank credit and hoarding/dishoarding alongside real saving and investment, the loanable funds theory is regarded as a more complete, monetary account of interest than the purely real classical version. …