Interest

There are four types of income i.e. rent, wages, interest, profit. Interest is paid for use of capital and it may be gross interest or net interest.

Classical theory of rate of interest- Marshall and Fisher

• Demand for saving
• Supply of saving
• Equilibrium of demand and supply of saving

Keynes’s Liquidity Preference Theory

1. The rate of interest is a purely monetary phenomenon and is determined by demand for money and supply of money. The theory is known as Liquidity Preference Theory.
2. According to Keynes, demand for money means demand for keeping funds in liquid form i.e. liquidity preference.
3. According to the theory, it is natural tendency to keep savings in liquid form to the extent possible but the liquidity can be parted with for certain period. To part with the liquidity for such certain period, the interest is the reward.
4. The demand for money may arise for a number of reasons i.e. transaction motives (day to day expenses), precautionary motives (against possibility of sudden need say for health), and speculative motive (to take advantage of possible gains).
5. The rate of interest is determined at the that point where demand and supply are equal, which is determined by liquidity preference.

The Demand for Money in a Two-Asset Economy: According to Keynes, people can keep two types of assets in their portfolio balance

(1) money in the form of currency and current deposits in the banks which earn no interest,

(2) long-term bonds, rate of interest and bond price is inversely related. The decision of people to balance their portfolios between money and bonds is influenced by two factors

1. Level of nominal income: Higher the level of nominal income in a two-asset economy, more the money people would want to hold their portfolio balance. This is because of transaction motive according to which at the higher level of nominal income, the people will purchase more of goods and services in their daily life, which require more money to be kept for transactions purposes.
2. Nominal rate of interest: Higher the nominal rate of interest, the lower the demand for money for speculative motive because a higher nominal rate of interest implies a higher opportunity cost for holding money. At higher rate of interest, holders of money can earn more incomes by holding bonds instead of money. Secondly, if the current rate of interest is higher than what is expected in the future, the people would like to hold more bonds and less money in their portfolio. On the other hand, if the current rate of interest is low (in other words, if the bond prices are currently high), the people will be reluctant to hold larger quantity of bonds (and instead they could hold more money in their portfolio) because of the inherent fear that bond prices would fall in the future causing capital losses to them.