How does the rate of interest is determined?

On basis of how the rate of interest is determined, there are various theories.  They are-

Classical theory of interest

This theory has defined interest as the price paid for the use of capital.  It is determined by both demand and supply of capital.  According to Keynes this theory is saving and investment theory.  Keynes has criticized this theory as unrealistic and indeterminate.

Loanable Fund Theory 

It is proposed by Wickshell.  Lindhal, Ohlin and Robertson have refined the theory.  Rate of interest is determined by the demand and supply of loanable funds.  Loanable funds are the sum of money supplied and demanded in the money market at any time.  Supply of loanable funds can be derived from four main sources namely – bank credit, dishoarding, disinvestment and savings.  The demand for loanable funds depends on three sources.  They are – investments, consumption and hoarding.  The rate of interest is determined at that point where the total demand and total supply of loanable funds are equal.

 

Liquidity preference Theory 

This theory is proposed by Keynes.  According to him interest is monetary factor.  It is determined by both demand for and supply of money.  Interest is the reward for parting with liquidity.  The demand for money depends on the liquidity preference of the people.  People hold or demand money basically for three motives namely – transactions, precautionary and speculative.  Supply of money is determined by the central bank of the country.

 

At any given period of time the supply of money is assumed to be fixed or perfectly inelastic in nature.  According to Keynes interest rate is determined by both demand for and supply of money in the market.  The rate of interest may fall below a certain level where the demand for money becomes perfectly elastic or infinite.  This point is called by Keynes as “liquidity trap”.  The concept of liquidity trap makes it clear that the rate of interest can never be zero or negative.

Modern theory of interest

This theory is associated with Hicks and Hansen.  The theory considers both monetary and real factors.  This theory explain about two curves – IS and LM curves.  IS curve shows the equilibrium between investment and savings in real sector.  LM curve shows equilibrium between liquidity preference i.e. demand for money and supply of money in monetary sector. The rate of interest as well as the level of income is determined at that place where these two curves intersect.