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Theory of Interest Rate

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 Chapter 8 Theory of Interest Rate

8.1 Introduction

In chapter 7, we have studied about different aspects of interest rate. Demand for money
depends on nominal rate of interest rate while investment depends on real interest rate and
marginal efficiency of capital. Nominal interest is the sum of real interest rate and the rate of
inflation while real interest rate is nominal interest rate corrected for the effects of inflation.
In this chapter we will study about different theories of interest rate. There are four theories
of interest rate, which are enumerated below:

1. The Classical Theory of Interest or the Real Theory of Interest ;

2. Neo-classical Theory of Interest or Lonable Fund Theory of Interest;
3. Keynes’ Theory of Liquidity Preference; and
4. Neo-Keynesian Theory of Interest or Hicks IS – LM Curve or Modern Theory of
Interest
8.2 The Classical Theory of Interest

The classical theory of interest rate is associated with the names of David Ricardo, Marshall,
A.C. Pigou, Cassels, Walras, Taussing and Knight. This theory is also known as the real
theory of interest rate because in determination of interest rate only real factors like
productivity and thrift are considered and monetary factors are not given any importance.
According to the classical theory, the rate of interest rate is determined by the intersection of
demand for and supply of investment (or capital). Interest is the price of investment because
firms borrow money for investment. Thus, investment depends on interest rate. Low interest
rate encourages high investment and high interest rate leads to reduction in investment. So,
investment is inversely related to interest rate. Household save their money to earn interest
rate. High interest leads to high saving and low interest leads to low saving. Thus, saving is
directly (or positively) related to interest rate. Firms’ demand for investment is fulfilled by
households’ saving. Thus, saving is supply and investment is demand in goods market. Thus,
interest rate in goods market is determined at the point where both supply of saving and
demand for investment crosses each other or intersect each other. Interest rate adjusts to
equilibrate the goods market through saving and investment. This is illustrated in the Figure
8.1, in which interest rate is shown on vertical axis and investment and saving are shown on
horizontal axis. R1 (i.e., 11) is the equilibrium rate of interest, which is determined at point E
where supply of saving and demand for investment intersects each other. This interest rate in
goods market is called natural rate of interest rate. When market rate of interest is more (i.e.,
R2 = 15) than the natural rate of interest (i.e., R1 = 11), saving will be greater (see point B in
Figure 8.1) than investment (see point A in Figure 8.1). As a result, interest rate will fall
down till equilibrium rate of interest is achieved. When market rate of interest is less (i.e., R)
than the natural rate of interest (i.e., R1 = 11); investment will be greater than saving. As a
result, rate of interest will be increased till equilibrium rate of interest is achieved.
 In classical theory saving is an increasing function of rate of interest, which may be
written as S (r), and investment is a declining function of rate of interest, which may be
written as I (r). Thus, rate of interest determining equilibrium in classical
classical theory will be given
by
I (r) = S (r) 8.1
The saving curve is moving upward because saving is directly related to interest rate.
For example, when interest rate is increasing from R to R1, saving is also increasing from C
to E (see Figure 8.1). This shows that as rate of interest increases,
increases saving also increases and
when rate of interest decreases,
decreases saving also decreases.

The investment demand curve is moving downward because investment is a declining

function of interest rate so that when rate of interest increase demand for investment falls
down and vice versa.

It must be noted here that saving in the classical theory of interest refers to supply of
capital. In other saving in this theory does not refer to money but to those goods and services,
service
which instead of being consumed are employed for productive purposes. It is on account of
this fact that the classical theory is also referred to as the real theory of interest.

8.3 Neo-classical
classical Theory of Interest or Lonable Funds
Fund Theory of Interest

Loanable funds theory is a reformulation of the classical saving and investment theory of rate
of interest. It incorporates monetary factors with the non-monetary
non monetary factors of saving and
investments. This loanable funds theory is associated with the names off Wickells,
Wickells and several
other Swedish economists and the British economists D. H. Robertson. This theory is an
improvement over old classical theory of interest. The loanable
l anable funds theory of interest rate is
based on the following assumptions:
 1. It is based on constant level of income corresponding to a constant level of
employment (i.e., full employment);
2. Resources in the economy are fully employed;
3. The market for loanable funds is full integrated and characterised by perfect mobility
of funds throughout the market;
4. There is perfect competition in the market so that lenders and borrowers are price
taker; and only one pure rate of interest prevails in the market;
5. The theory uses partial-equilibrium approach in which all factors other than the rate of
interest that might influence the demand or supply of loanable funds are assumed to
be held constant. In other words it assumes that the rate of interest does not interact
with other macro variables
6. Supply of money (M) is given as it is influenced by monetary authorities;
7. Supply of money is independent of rate of interest;
8. Supply of money is exogenous variable;
9. The theory is stated in ‘flow’ terms, considering flow demand and supply of loanable
funds per unit of time.
10. Dishoarding is considered to be interest elastic; and
11. Saving depends on income rather than interest rate.

According to this theory, the rate of interest is determined by the demand for and
supply of loanable funds. Classical theory of interest considered only saving out of current
income in the supply of saving while neo-classical economists considered not only saving but
also bank credit, dishoarding and disinvestment. In classical theory, only saving was
available for investment while in loanable funds theory of interest of neo-classical economists
not only savings, but also hoarded wealth, bank loans, disinvestment wealth are another
sources of funds available for investment to the borrowers. Since loanable funds theory of
interest considered both savings of classical theory of interest and bank loans, dishoarding,
and disinvestment; it is often referred as real as well as monetary theory of interest. Thus, it is
both real and monetary theory of interest.

The supply of loanable funds (SL) in loanable funds theory of interest is given by

SL = S + H + ∆M 8.2

Where, S is aggregate saving of all households and firms net of their dissaving; H is
aggregate dishoarding of money or cash; and ∆M is incremental supply of money, which is
under the control of monetary authorities.

The demand for loanable funds (DL) is given by

DL = I + ∆MD 8.3

Where, I is gross investment expenditure; and ∆MD is incremental demand for hoarding
money.

The equilibrium rate of interest is determined at a point where

 DL = SL 8.4

I + ∆MD = S + H + ∆M 8.5

The neo-classical’s
classical’s loanable funds theory of interest rate is illustrated in the Figure 8.2,
8.2
in which rate of interest is shown along Y axis (i.e., on vertical axis) and loanable funds is
shown along X axis (i.e., on horizontal axis).
axis) Supply of money (M) is verticalrtical and it is fixed
and/ or given because it is controlled by monetary authorities. When rate of interest is zero,
saving is Rs.20 because in this theory saving is independent of rate of interest and it depends
on income. Thus, saving (S) is a steep curve curve as compared to dishoarding (H) curve.
Dishoarding curve is a flat because it is interest elastic. In other words, dishoarding depends
on interest. As increase in interest rate brings out more hoarded funds and a decrease in
interest rate brings out less of hoarded funds. Thus, dishoarding funds is directly related to
interest rate. M + S + H is supply of loanable funds. M + S+ H is the horizontal summation of
the supply of money (M), saving (S), and dishoarding (H). Investment curve (I) is moving
downwardd because investment is a declining function of interest rate. As interest rate
increases, demand for investment
investment decreases and vice versa.

Intersection of supply of loanable funds (M + S + H) and demand for investment determines

the rate of interest. The rate of interest is determined at point E (i.e., 5.9 per cent or 6 per cent
approximately, see Figure 8.2)
The above Figure 8.2 is based on the following Table 8.1

Table 8.1: Demand for and Supply of Loanable Fuds

Horizontal Vertical axis Supply of Savings Dishoarding Investment Supply of
axis (Y) Money (S) (H) (I) Loanable Funds
(X) Interest Rate (M) =M+S+H
Loanable (in per cent)
Funds
(1) (2) (3) (4) (5) (6) (7)

0 0 20 --- --- --- ---

10 5 20 --- 4 --- ---

20 10 20 0 6 --- ---

30 15 20 5 8 --- ---

40 20 20 10 10 25 ---

50 25 20 15 12 20 ---

60 30 --- 20 14 15 ---

70 --- --- 25 16 10 4 (20+30+16 =

66)

80 --- --- -- 18 5 6

90 --- --- --- 20 0 8

100 --- --- --- 22 --- 10 (20+40+40 =

100)

Explanation of the Table 8.1 is very important to understand the explanation of the
Figure 8.2. at every rate of interest, supply of money is Rs.20 because it is under the control
of monetary authorities like the Reserve Bank of India. Now, see the saving column number
4, in which it is clear that the saving is Rs. 20 (see column 1 of Table 8.1) at 0 per cent rate of
interest (see column 4) because here, saving depends on income and not on rate of interest.
This is why saving curve is steeper as compare to dishoarding curve (see Figure 8.2). Now,
move to see dishoarding column number 5, in which as rate of interest is increasing from 4
per cent to 6 per cent, supply of dishoarding is increasing from Rs.10 to Rs.20 (see column
number 1). As rate of interest is increasing (see column number 5) supply of dishoarding is
increasing (see column number 1). Investment is a declining function of interest rate, which is
explicitly shown in column number 6 and 1. As interest rate decreases from 25 per cent to 20
per cent (see column number 6 of Table 8.1), demand for investment increases from Rs. 40 to
50 (see column number 1). Column number 7 is horizontal summation of supply of money
(M), saving (S), and dishoarding (H). In column 7, we observe that as rate of interest is
increasing from 4 per cent to 10 per cent, supply of loanable funds is increasing from Rs. 66
(see Figure 8.2) to Rs.100 (see column 1 of the Table 1 and see Figure 8.2). Thus, rate of
interest, according to neo-classical theory or loanable funds theory of interest is determined at
point E (see Figure 8.2), where supply of loanable funds (M + S + H) intersects demand for
investment as shown in the Figure 8.2.

Lonable funds theory is a flow theory because it involves the linking of the interest rate
with investment and hoarding of funds on the demand side with savings, dishoarding, and
bank money on the supply side. These are all flow variables. As such, the theory hypothesises
that it is the ‘flow equilibrium’ (or the equilibrium between the two flows) of loanable funds,
which determines the rate of interest.

8.4 Keynes Theory of Liquidity Preference

Before going to study the Keynes theory of liquidity preference, let us recall classical theory
of interest and lonable theory of interest. In classical theory of interest, rate of interest is a
real phenomenon and it is determined in the goods market by the intersection of savings and
investment. The rate of interest, according to Keynes, is a purely a monetary phenomenon, a
reward for parting with the liquidity, and the rate of interest is determined in the money
market by the intersection of demand for and supply of money. According to loanable funds
theory of interest, rate of interest is determined by the intersection of supply of savings and
demand for investment. Loanable funds theory of interest is different from classical theory of
interest in the sense that it includes bank loans, dishoarding, and disinvestment besides
savings in supply of loanable funds. With this background in mind let us move to study the
Keynes theory of liquidity preference.

In his classic work, “The General Theory of Employment, Interest and Money
(1936),” Keynes offered his view of how the interest rate is determined in the short run. That
explanation is known as the theory of liquidity preference because it posits that the interest
rate adjusts to balance the supply and demand for the economy’s most liquid asset – money.
The theory of liquidity preference posits that the interest rate is one determinant of how much
money people choose to hold. The reason is that the interest rate is the opportunity cost of
holding money: it is what you forgo by holding money in liquid or cash, which does not bear
interest rate. When the interest rate rises, people want to hold less of their wealth in the form
of money/liquid/cash1.

According to Keynes, rate of interest will be determined at the point where demand
for money (Md) equals supply of money (MS). This can be written as,

Md = MS 8.6

Keynes said that the money was demanded for three motives: (i) the transaction motive; (ii)
the precautionary motive; and (iii) the speculative motive. Ever since this threefold

1. Mankiw, N, Gregory, 2003, Macroeconomics, Worth Publishers: 271

classification
ion of motives has become standard stock-in-trade
stock trade of monetary economics. The
demand for money is summed up in the following equation:

Md = L1 (Y) + L2 (r) 8.7

Where, Md is demand for money. The first component of demand for money is L1 (Y)
representing the transactions and precautionary demand for motive and both (i.e., transaction
and precautionary motives) are increasing function of income so that the first component of
demand for money becomes L1 (Y). The second component of demand for f money is L2 (r)
representing the speculative demand for money, which is a declining function of rate of
interest such as if rate of interest (r) increases, speculative demand for money decreases. So,
speculative demand for money depends on rate of interest
interest rate, so that the second component
of demand for money becomes L2 (r). like other economists, Keynes also assumed that the
supply of money (MS) to be exogenously given by the monetary authority, so that

MS = Ḿ 8.8

Where, MS is the supply of money, and money Ḿ is given by the monetary authority.

The money market will be in equilibrium when Md = MS, i.e.,

L1 (Y) + L2 (r) = MS 8.9

The determination of rate of interest, according to Keynes liquidity preference theory

of interest is illustrated in the Figure 8.3,
8.3, in which rate of interest is shown along vertical axis
and
demand for money and supply of money is shown on horizontal axis. The demand for money
is represented by the downward sloping curve labeled Md = L1 (Y) + L2 (r). The first
component of demand for money, namely L1 (Y) representing Keynes transaction and
precautionary demand for money is assumed to be autonomous of rate of interest, r. therefore,
it is shown by the vertical line L1 (Y). The second component of demand for money, L2 (r)
representing speculative demand for money, is not shown separately in our figure, because
the Md curve itself becomes the L2 (r) curve when it is read with L1 (Y) as the origin in place
of 0, which amounts to be subtracting L1 (Y) horizontally from the Md curve. Mo, M1, and
M2 are supplies of money, which are given exogenously by monetary authority.

The money market will be in equilibrium at point E, where Md equals supply of money,
S
M such that L1 (Y) + L2 (r) equals M0 at point E. The rate of interest, r1 is determined at
point E, where L1 (Y) + L2 (r) equals M0. At any other rate of interest except r1, there will be
disequilibrium in the money market and the working of the market forces will push the rate of
interest towards r1. For example, at lower rate of interest, there will be excess demand for
money. As a result, rate of interest will increase towards r1. When rate of interest is high,
there will be less demand for money. Consequently, rate of interest will fall.

Now, let us understand why portion CB of demand curve, AB is called liquidity trap? The
demand for money curve, AB is sloping downward rapidly from point A to point C. When
rate of interest was 15 per cent demand for money was Rs.28. when rate of interest fall to r1
= 7 per cent, demand for money increases to Rs.50. This shows that when rate of interest falls
down people demand more money because the opportunity cost of holding money or cash at
low rate of interest will be very less. This is why the people demand more money when rate
of interest is low because the cost of holding money is less (cost of holding money is interest
rate on money) and demand for money falls down when rate of interest increases. This is why
demand curve for money, AB is sloping downward rapidly from point A to point C rapidly.
But demand curve become horizontal from point C to point B. In other words, we can say
that demand curve for money between point C and B is infinite interest elastic. This infinite
interest elasticity of the liquidity preference curve (or CB portion of the demand for money
curve, AB) is called liquidity trap.

Now, let us examine why the liquidity preference curve becomes perfectly elastic in
respect of interest rate after the point C (see Figure 8.3). As shown in the Figure 8.3, the
liquidity preference (LP) curve becomes flat at 5.4 per cent rate of interest (see CB portion of
LP curve, AB in Figure 8.3). after point C, the rate of interest will not decline even after
increasing in supply of money (i.e., see supply of money, M1) because all additional money
will be kept by people in the form of cash with themselves. They shall not invest even a small
part of these in bonds because of the following reasons, which are given stepwise:

1. The people do not expect rate of interest to fall;

2. If rate of interest will not fall; bond prices will not increase (since there is inverse
relationship between interest rate and bond price);
3. If bond price does not increase then there is not possibility of making profit in
investing bonds. Therefore, people are keeping all additional money (i.e., after point
 C in Figure 8.3) with themselves. This is said that at 5.4 per cent rate of interest,
economy is caught in liquidity trap.

There are another reasons for liquidity trap, which are given below stepwise:

1. 5.4 per cent rate of interest is so low that there is every possibility of its rising in
future beyond 5.4 per cent;
2. If rate of interest increases in future then bond price will decline in future (since
bond price and interest rate are inversely related to each other);
3. Anyone who buys bonds at present will suffer a heavy loss in future because bond
price will decline in future;
4. When people expect falling of bond price in future then people keep all additional
money with themselves in order to invest in bond in future. This is why at 5.4 per
cent rate of interest, CB portion of liquidity preference curve of demand for
money curve, AB is caught in liquidity trap.

Thus, we see here in Keynes theory of liquidity preference that when supply of
money increases, rate of interest falls down but after reaching a low level of rate of interest
i.e., at 5.4 per cent rate of interest; increase in supply of money will not make rate of interest
to fall down. This is something unique about the rate of interest i.e., rate of interest cannot
fall to zero. But the same cannot be said about the price of the commodity. If the supply of
commodity is increased to a very large extent in relation to its demand, there is every
possibility of its price falling to zero. But this is not so with the price of the money (i.e. the
rate of interest). Whatever be the increase in supply of money, the rate of interest, according
to Keynes shall never fall to zero due to this peculiarity of liquidity preference.

8.5 Neo-Keynesian Theory of Interest or Hicks IS – LM Curve or Modern Theory of

Interest

Classical economists determined the rate of interest with the help of the saving and
investment in the goods market. Neo-classical economists determined the rate of interest (r)
with the help of demand for and supply of loanable funds by incorporating both real sectors
and monetary sectors. Keynes completely denied the real factors represented by real savings
and investment (so much emphasized by both classical and neo-classical economists) in
determination of rate of interest (r). Keynes tried to determine rate of interest with the help of
the demand for and supply of money in the money market as L1 (Y) + L2 (r) = MS, which
contained besides r, another unknown income (Y) in his demand for money, Md functions.
This is invalid because unless we know the value of Y, the equilibrium equation {(i.e., L1 (Y)
+ L2 (r) = MS} cannot be used to determine r. Keynes’ solution procedure involved him into
the circularity of reasoning that is Keynes says that rate of interest, r determines investment
and investment determines income through multiplier process. Thus, r influences income, Y
and is influenced by Y. This represents a case of join determination of rate of interest. Hicks
(1937) removed this analytical flaw in keynes’ model through IS-LM curve. Thus, Hicks IS-
LM model is also known as neo-Keynesian model. Now it is widely believed that it is both
real or goods market forces and money market forces determine rate of interest and real
income. The commonly accepted model for joint determination of rate of interest and the real
income is Hick’s IS-LM model. The key feature of Hicks’ (or Keynesian) model is the joint
determination of rate of interest and the real income. It also shows the interaction of the
commodity market and the money market.

Hicks and Learner have synthesized the theory of both classical’ saving-investment
theory, and Keynes’ liquidity preference theory into a new theory, which is known as Hicks’
IS-LM model. This theory is also known as the determinate theory of interest rate (since
classical theory of interest; loanable funds theory of interest, and Keynes liquidity preference
theory were all indeterminate theory of interest because these theories failed to relate rate of
interest with the income). This theory has taken out four important elements viz; (i) saving,
and (ii) investment from classical theory of interest, and (iii) liquidity preference or demand
for money/ cash, and (iv) supply of money from keynes’ liquidity preference theory to
determine rate of interest and real income jointly in both commodity market and money
market with the help of IS and LM curve. IS curve has been derived from the combination of
saving and investment in commodity market. Thus, the IS curve shows us, for any given
interest rate, the level of income that brings the goods market into equilibrium. So, the IS
curve represents equilibrium in the market for goods and services. The IS curves shows the
combination of the interest rate and the level of income that are consistent with equilibrium in
the market for goods and services. LM curve has been derived from the combination of
liquidity preference and supply of money in the money market. Thus, the LM curve tells us
the interest rate that equilibrates the money market at any level of income. So, LM curve
represents the equilibrium in the money market for real money balances. The LM curve
shows the combinations of the interest rate and the level of income that are consistent with
equilibrium in the market for real money balances.

Note that IS curve does not determine either income, Y or the interest rate, r. instead,
the IS curve is a relationship between Y and r arising in the market for goods and services, or
equivalently, the market for loanable funds. To determine the equilibrium of the economy, we
need another relationship between these two variables and that is LM curve. The IS and LM
curves together determine the interest rate and the national income in the short run when the
price level is fixed.

Now, let us see how these two curves viz; IS and LM are constructed. The derivation
of IS curve is shown in the Figure 8.4 (A) in which rate of interest is shown along vertical
axis and saving and investment is shown along horizontal axis. A curve sloping downward is
an investment curve, I and a curve sloping upward is a saving, S curve. Both saving and
investment are functions of rate of interest. But here, in the Figure 8.4 (A) besides, saving and
investment curve one more important variable is introduced and that is income (Y). But in a
two dimensional figure, a third variable (Y in the present case) cannot have its independent
axis. Therefore, it is shown as a parameter of the S and I curves such as S; Y1 and I; Y. After
introducing income curve (Y), both S and I are also become function of income, Y. The S
lines are drawn upward sloping, because savings are hypothesized to be an increasing
function of rate of interest, r. but since savings are also influenced by Y, there is a whole
family of such rising S curves,
curves, one for each value of Y. For example, as Y1 is increasing to
Y2, Y3, and Y4, (i.e., Y1= Rs.35, Y2 = Rs.45,Y3 = Rs. 55, and Y4 = Rs.65) saving is also
increasing along withith the Y from S; Y1 to S;Y2 to S; Y3 to S; Y4. When income level is Y1
= Rs.35, the equilibrium between saving and investment is at point E1. When income level is
Y2 = Rs 45, the equilibrium between saving and investment is at point E2 and so on till
income level Y4 = Rs.65. In other words, we can say that at point E1 income, Y1 is Rs.35, as
income increases from Y1 to Y2 = Rs.45, rate of interest falls from r4 = 20 per cent to r3 = 16
per cent. So, in the Figure 8.4 (A) it is very clear that as income increases
increases fromY1 to Y2 to
Y3, and Y4, rate of interest falls from r4 to r3 to r2, and r1. When we plot equilibrium
relationship between Y and r in the Figure 8.4 (B), we get a downward sloping curve, called
IS curve. This curve is the locus of alternative combinations
combinations of Y and r at which the
commodity market will be in equilibrium. At all other points, except points lies on the IS
curve shows disequilibrium in the commodity marketWe
marketWe also observe that as Y is increasing,
the equilibrium between investment and saving establishes at low rate of interest (see Figure
8.4, A). Thus, as income increases, investment-saving
investment saving curve (IS) falls downward with the
falling interest rate as shown in the Figure 8.4 (B).
(B). Thus, the IS curve shows the combination
of the interest rate
ate and the level of income that are consistent with equilibrium in the market
for goods and services.

The horizontal distance between the two S curves at any rate of interest shows by how
much S increases when Y increases from Y1 to Y2 and so on. The ratio of the two values will
give the value of the marginal propensity to save (∆S/∆Y),
( , which cannot be shown in this
figure. A similar explanation holds for the investment, I curve for which two things have to
be remembered: (i) investment is a declining
declining function of rate of interest, and (ii) the rightward
shift in the investment curve for the given increase in Y from Y1 to Y2 is a smaller than for
the saving. This means that marginal propensity to save is greater than the marginal
propensity to investment.
ment. This is based on the Hicks’ assumptions. For stability, Hicks’
assumed that marginal propensity to save (with respect to income) is greater than the
marginal propensity to investment (with respect to income). In simple words, it means that a
small increase
crease in income induces a large increase in savings than it does in investment. At
points to the right of the IS curve, this market will have excess of saving over investment or
deficiencies of demand. This will induce income to fall (Keynes theory) and/ or rate of
interest to fall (classical theory).
theory)

The money market can be analysed on the similar lines. Supply of money is shown on
vertical axis and rate of interest is shown on horizontal axis in the Figure 8.5 (A). Because of
the fixity of the supply of money (M), it is shown vertical in the Figure 8.5
8. (A). Demand for
money is an increasing function of income and decreasing function of rate of interest. Student
must remember here that demand for money means demand for cash or demand for liquidity
preference. Since demand for money/ liquidity preference is a declining function of rate of
interest, it is shown by downward sloping L curves (which represents demand for money
function, Md) in the Figure 8.5 (A) Four such curves have been drawn in the Figure 8.5 (A)
one each for the different level of Y as L;
L; Y1, L; Y2, L; Y3; and L; Y4. At the given supply
of money, M, increase in demand for money increases rate of interest. In other words, we can
say that as income, Y increases from Y1 to Y2 to Y3, rate of interest increases from r1 to r2
to r3. If the exogenously
enously given supply of money is fixed at M, the Figure 8.5 (A) shows four
alternative equilibrium points (such as E1, E2, E3, and E4) one for each level of income, Y.
At the given supply of money, M, as income, Y increases from Y1 to Y2 to Y3, and to Y4,
equilibrium rate of interest also increases. This means that, for money market equilibrium, a
higher level of Y is associated with the higher level of rate of interest, r. This makes a sense,
because at higher Y more money will be demanded; given the fixed supply of money, M. The
money market can clear only if rate of interest increases along with the increase in Y to
choke off the excess demand for money. The money market shows that as income increases;
rate of interest increases. When we plot the relationship between income,income Y and rate of
interest, r, we get an upward sloping curve, called LM curve as shown in the Figure 8.5 (B) in
the money market. The LM curve shows the combinations of the interest rate and the level of
income that is consistent with equilibrium in the money money market for real money balances.
Points to the right of the LM curve will show excess demand for money and point to the left
of the curve shows excess supply of the money. Points to the right of the LM curve shows
excess demand for money, this leads to a rise in the interest rate as a result income will fall
down. Points to the left of the LM cure show excess supply of money in the market that leads
to fall in the rate of interest, consequently, income increases.

After deriving IS and LM curve, we are now now in position to operate with the Hicks’ IS-LM
IS
apparatus as depicted in the Figure 8.6 in which rate of interest, r is shown along vertical axis
and income, Y

is shown along horizontal axis. The IS curve shows equilibrium in commodity market and the
LM curve shows the equilibrium in the money market. The intersection of both the IS and
LM curve at point E at Y = Rs. 40 and r = 20 per cent, shows simultaneous equilibrium in
both commodity market and money market and as such are the required equilibrium values.
va
This model gives simultaneous equilibrium values of Y and r. for the rest it is like Keynes’
model. For example, this model, too, takes output to be demand determined till the point of
full employment output is reached;
reached it is a fix-price model; given wages, employment and
price level are determined as in Keynes’ model.
model. Let us see how output is demand determined.
When income increases,, saving increases (see Figure 8.4 A). This shows deficiency of
demand as a result income or output falls down. This is why like Keynes, output is demand
determined in this model.

Now, we will study how fiscal policy and monetary policy shifts the IS curve and LM
curve respectively. First, we will study the effects of fiscal policy on the IS curve. Here, the
IS curve shows
hows us, for any given interest rate, the level of income, Y that brings goods market
into equilibrium. The IS curve is drawn for a given fiscal policy; that is, when we construct

the IS curve we hold government purchases and taxes fixed. The figure 8.7 is drawn for fixed
rate of interest and thus for a given level of planned investment. Increase in fiscal expenditure
(i.e., increase in government purchases and/ or decrease in taxes) expands expenditure
exp and
income that leads to shift in the IS curve outward (or rightward) to IS1 curve as shown in the
Figure, 8.7. Increase in government purchases and reduction in taxes increases income from
Y1 = Rs. 25 to Y2 = Rs 50 at the given rate of interest, r = 22 per cent. Changes in fiscal
policy that increases the demand for goods and services shifts the IS curve to the right, as
shown by IS1 curve. Changes in fiscal policy that decreases the demand for goods and
services shifts the IS curve to the left, as a shown by IS0 curve in the Figure 8.7. In the
commodity market, we analyse the effects of change in fiscal policy on the level of income
for a given rate of interest. This means that in commodity market, the IS curve shows that it is
income that equilibratestes the commodity market for a given rate of interest. The IS curve
shows the inverse relationship between the interest rate and the income.

Through IS curve, we can interpret the loanable funds theory. For example, expansion
in fiscal policy (i.e., increase in the government expenditures) increases income from Y1 to
Y2 (see Figure 8.7), raises saving and thus lowers the interest rate that equilibrates the supply
and demand for loanable funds.

Now, let us analyse the effect of monetary policy on the LM curve. We have studied a
short while ago that IS curve analyse the effects of change in fiscal policy on the level of
income for given rate of interest. Now, we will study the effects of change in monetary policy
on the rate of interest for a given level
level of income. As we have seen earlier, that the
equilibrium interest rate also depends on the supply of real money balances, i.e.,

Real money balance = 8.10

Where, M represents the supply of money, and P represents the price level. level This means that
LM curve is drawn for a given supply of real money balances. If monetary authority like the
Reserve Bank of India changes in the supply of money, the LM curve shifts. This is
illustrated in the Figure 8.88 in which rate of interest, r is shown on the vertical axis and real
money balances, M/P or income, Y is shown on the horizontal axis. Suppose the money
market is in equilibrium is at point E at LM curve,

Where, rate of interest and income or real balances

balances are in equilibrium. When monetary
authority like the Reserve Bank of India increases the money supply at given real money
balances, M/P or at given income, M/P , then the rate of interest decreases, which leads to
shift the LM curve downward or rightward to LM0 and the equilibrium in the money market
is achieved at low rate of interest, r0. When the supply of money decreases;
decreases the rate of
interest increases, which leads to increase in the rate of interest rate that shifts the LM curve
upward or leftward to LM1; and the money market will achieve equilibrium at high rate of
interest,, r1 at point E1. Thus, the LM curve is drawn for a given supply of real money
balances. Decrease in the supply of real money balances shifts the LM curve upward (see
LM1 in the Figure 8.8) and increase in the supply of real money balances shifts the LM curve
downward (see LM0 curve in the Figure 8.8). The LM curve shows the positive relationship
between the interest rate and the income.
8.6 Summary
There are four theories of rate of interest. They are: (i) the classical theory of interest; (ii) the
loanable funds theory of interest; (iii) the Keynes liquidity preference theory; and (iv) modern
theory of interest or Hicks IS-LM model. According to the classical theory of interest, rate of
interest is a real phenomenon and it is determined in the commodity market by the real
factors i.e., savings and investments at a level which equates the two. In classical theory
saving is an increasing function of rate of interest, which may be written as S (r), and
investment is a declining function of rate of interest, which may be written as I (r). Thus, rate
of interest determining equilibrium in classical theory will be given by
I (r) = S (r) 8.1

The rate of interest is determined in the goods market at the point where saving and
investment intersects each other. According to classical economists interest arises because
capital is productive and it is scarce in relation to demand.

Loanable funds theory is a reformulation of the classical saving and investment theory
of rate of interest to take note of the phenomenon of hoarding, dishoarding, and autonomous
changes in the stock of money (new injection of money for demand and supply of the flow of
loanable funds in the market ). It incorporates monetary factors with the non-monetary factors
of saving and investments.

The supply of loanable funds (SL) in loanable funds theory of interest is given by

SL = S + H + ∆M 8.2

Where, S is aggregate saving of all households and firms net of their dissaving; H is
aggregate dishoarding of money or cash; and ∆M is incremental supply of money, which is
under the control of monetary authorities.

The demand for loanable funds (DL) is given by

DL = I + ∆MD 8.3

Where, I is gross investment expenditure; and ∆MD is incremental demand for hoarding
money.

The equilibrium rate of interest is determined at a point where

DL = SL 8.4

I + ∆MD = S + H + ∆M 8.5

Quantity theory of money says that it is money income or price level which brings
equilibrium in the money market while Keynes says that is rate of interest that brings
equilibrium in the money market. The rate of interest, According to Keynes is a monetary
phenomenon, a reward for parting with the liquidity. According to liquidity preference
theory, the rate of interest is determined at the point where demand for money (Md) equals
supply of money (MS). This can be written as,

Md = MS 8.6

The money market will be in equilibrium when Md = MS, i.e.,

L1 (Y) + L2 (r) = MS 8.9

The Cambridge theory (or the QTM) suppresses the role of rate of interest and Keynes theory
suppresses the role of income. Hicks and Learner have synthesized the theory of both
classical’ saving-investment theory, and Keynes’ liquidity preference theory into a new
theory, which is known as Hicks’ IS-LM model. Hicks’ IS-LM model explains the joint
determination of both rate of interest and real income. IS curve has been derived from the
combination of saving and investment in commodity market. Thus, the IS curve shows us, for
any given interest rate, the level of income that brings the goods market into equilibrium. So,
the IS curve represents equilibrium in the market for goods and services. The IS curves shows
the combination of the interest rate and the level of income that are consistent with
equilibrium in the market for goods and services. LM curve has been derived from the
combination of liquidity preference and supply of money in the money market. Thus, the LM
curve tells us the interest rate that equilibrates the money market at any level of income. So,
LM curve represents the equilibrium in the money market for real money balances. The LM
curve shows the combinations of the interest rate and the level of income that are consistent
with equilibrium in the market for real money balances. The IS and LM curves together
determine the interest rate and the national income in the short run when the price level is
fixed.

Key Concepts

• IS Curve: IS curve has been derived from the combination of saving and investment
in commodity market. Thus, the IS curve shows us, for any given interest rate, the
level of income that brings the goods market into equilibrium. So, the IS curve
represents equilibrium in the market for goods and services. The IS curves shows the
combination of the interest rate and the level of income that are consistent with
equilibrium in the market for goods and services.
• LM Curve: LM curve has been derived from the combination of liquidity preference
and supply of money in the money market. Thus, the LM curve tells us the interest
rate that equilibrates the money market at any level of income. So, LM curve
represents the equilibrium in the money market for real money balances. The LM
curve shows the combinations of the interest rate and the level of income that are
consistent with equilibrium in the market for real money balances.
 Important Points

• The classical theory of interest rate is associated with the names of David Ricardo,
Marshall, A.C. Pigou, Cassels, Walras, Taussing and Knight. This theory is also
known as the real theory of interest rate because in determination of interest rate only
real factors like productivity and thrift are considered and monetary factors are not
given any importance.
• Loanable funds theory is a reformulation of the classical saving and investment theory
of rate of interest. It incorporates monetary factors with the non-monetary factors of
saving and investments. This loanable funds theory is associated with the names of
Wickells, and several other Swedish economists and the British economists D. H.
Robertson. This theory is an improvement over old classical theory of interest.
• The rate of interest, according to Keynes, is a purely a monetary phenomenon, a
reward for parting with the liquidity, and the rate of interest is determined in the
money market by the intersection of demand for and supply of money.
• Hicks and Learner have synthesized the theory of both classical’ saving-investment
theory, and Keynes’ liquidity preference theory into a new theory, which is known as
Hicks’ IS-LM model.

Questions for Review

1. What are the assumptions of loanable funds theory of interest rate?

2. Write in brief different theory of interest rate determination.
3. Explain modern theory of interest rate.

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