Interest: the loanable funds theory and Keynes' liquidity preference theory

1. Meaning of interest

Interest is the price paid for the use of capital (or, in the modern view, of money or loanable funds) for a period of time. It is expressed as a rate per cent per annum.

• Gross interest: the total payment a borrower makes. It includes net (pure) interest plus payment for risk, for the lender’s trouble and management of the loan, and for inconvenience.
• Net interest: the payment for the use of capital alone, where there is no risk or inconvenience (as on government bonds).

Why is interest paid? Borrowers pay because capital is productive (it yields a return) or because they want to consume now. Lenders demand it because lending means waiting, abstinence from present consumption, and parting with liquidity. Different theories stress different reasons.

2. The classical background

The classical theory (Marshall, Pigou, Fisher) is a real theory: interest is determined by the demand for capital for investment and the supply of saving. Investment demand rises as the rate falls (the marginal productivity of capital); saving rises as the rate rises (the reward for abstinence or waiting). The rate settles where saving equals investment. It ignores money, hoarding and bank credit.

3. Loanable funds theory

The neo-classical theory of Knut Wicksell, Bertil Ohlin, D.H. Robertson, Gunnar Myrdal and others. Interest is the price of loanable funds (credit), and is determined by the demand for and supply of such funds. It adds monetary factors to the classical real ones.

Supply of loanable funds:

1. Saving (S) by households and firms, rising with the rate of interest.
2. Dishoarding (DH): release of past idle cash balances; more is dishoarded at higher rates.
3. Bank credit (BC): new money created by banks, more at higher rates.
4. Disinvestment (DI): funds released when machines are not replaced.

Demand for loanable funds:

1. Investment (I) in capital goods, more at lower rates.
2. Hoarding (H): desire to hold idle cash, greater at lower rates.
3. Dissaving (DS): consumption loans by those living beyond current income, and government borrowing.

Equilibrium: the rate of interest is where S + DH + BC + DI = I + H + DS. Described diagram: the total supply curve slopes upward and the total demand curve downward, and they cross at the equilibrium rate.

Merits: more realistic than the classical theory because it includes money and bank credit; it explains why the rate changes when banks expand or contract credit.

Criticism: (i) it combines real (saving, investment) and monetary (hoarding, credit) factors, which some regard as inconsistent; (ii) it assumes saving responds to the rate of interest, whereas saving depends mainly on income; (iii) it is indeterminate, because saving depends on income, which in turn depends on investment and so on the rate itself (Hansen’s criticism); (iv) it assumes full employment.

4. Keynes’ liquidity preference theory

J.M. Keynes (General Theory of Employment, Interest and Money, 1936) gave a purely monetary theory: “interest is the reward for parting with liquidity for a specified period”. Money is the most liquid asset; people prefer to hold wealth in that form. To persuade them to lend it, or to hold bonds instead, they must be paid interest. The rate is determined by the demand for money (liquidity preference) and the supply of money.

Demand for money: three motives

1. Transactions motive: money held to meet day-to-day expenses between the receipt of income and its spending. Depends on the level of income.
2. Precautionary motive: money held against emergencies, illness, accident or unemployment. Also depends mainly on income.
3. Speculative motive: money held to take advantage of expected changes in the price of bonds. Bond prices and interest rates move inversely. When the rate is high (bond prices low) people expect it to fall and bond prices to rise, so they buy bonds and hold little cash. When the rate is low they expect it to rise, so they hold cash. Speculative demand is therefore inversely related to the rate of interest.

Total demand for money: L = L₁(Y) + L₂(r), where L₁ is the transactions and precautionary demand (a function of income) and L₂ the speculative demand (a function of the rate of interest). The liquidity preference curve slopes downward from left to right and becomes flat at a low rate.

Supply of money is fixed by the monetary authority (in India, the RBI) and does not depend on the rate of interest: a vertical line.

Equilibrium: the rate of interest is where the demand for money equals the supply. Described diagram: money on the horizontal axis, rate on the vertical; the downward-sloping LP curve cuts the vertical money-supply line at E, giving the rate Or. An increase in money supply (the line shifts right) lowers the rate; an increase in liquidity preference (LP shifts up) raises it.

Criticism:

1. Indeterminate (Hansen): the transactions demand depends on income, and income depends on the rate of interest through investment. The rate cannot be known without knowing income, and vice versa. The same objection applies to the loanable funds theory; Hicks and Hansen combined the two in the IS–LM framework.
2. Ignores real factors such as the productivity of capital and thrift.
3. Saving comes first: Jacob Viner objected that without saving there is no liquidity to part with, so liquidity preference presupposes saving, the real factor Keynes left out.
4. It is a short-run theory; in the long run real factors dominate.
5. Even without liquidity preference interest would be paid, since capital is productive.

5. Comparison

Principles of Economics covers the loanable funds theory in interest and profit.

How this is examined

February 2025 set “Briefly analyse Keynesian theory of interest” (16 marks, 100-mark paper); January 2026 set “Write a note on Keynesian theory of interest” (6 marks, 80-mark paper). For the long answer: meaning of interest, Keynes’ definition, the three motives, L = L₁(Y) + L₂(r), money supply, equilibrium with diagram described, liquidity trap and criticism. For the loanable funds theory, which the syllabus names, list the sources on each side and write the equilibrium equation.