Theories of Interest

Meaning of Interest

Interest is the price paid for the use of capital — the reward a borrower pays a lender for the use of loanable funds over a period of time, usually expressed as a percentage rate per annum.

Gross Interest and Net Interest

The interest actually paid on a loan — gross interest — is not a pure return on capital alone. Economists split it into several components: net interest, the pure reward for parting with capital (for "waiting" or postponing consumption); a reward for the risk of default by the borrower; a reward for the inconvenience/management involved in lending; and occasionally a payment covering inflation risk. Net interest is what remains once these risk and inconvenience premiums are stripped out — the pure price of capital itself, comparable across riskless loans.

Classical (Real) Theory of Interest

The classical economists explained interest using real forces of saving and investment, treating money merely as a veil. The supply of capital (savings) comes from households postponing present consumption — an act requiring "abstinence" or "waiting," for which savers must be compensated. The demand for capital (investment) comes from firms wanting to borrow funds to invest, driven by the productivity of capital. Interest is the price that equates saving (supply) and investment (demand) in the capital market, much as any price equates the demand and supply of a good.

Loanable Funds Theory

Developed by neoclassical economists such as Knut Wicksell and Bertil Ohlin, the loanable funds theory widens the classical theory by including monetary as well as real factors. The supply of loanable funds comes from savings, dishoarding (people releasing previously idle money balances), and new bank credit; the demand for loanable funds comes from investment, government borrowing, and hoarding (people wanting to hold idle balances). The rate of interest is determined where the demand for and supply of loanable funds are equal:

Because it includes bank credit and hoarding/dishoarding alongside real saving and investment, this theory is considered a more complete, monetary theory of interest compared with the purely real classical version.

Keynesian Liquidity Preference Theory …