Loanable and Classical

8/9/2019 Loanable and Classical

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Savings and Investment


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InterestCapital gets reward for itsservices which is termed asInterest. Interest is the rewardfor capital.Before, defining the reward of

capital which is known asinterest. Lets understand whatcapital is:


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Capital

Capital

Fixed Capital Variable Capital

Capital is divided into two:

The Whole of fixed as well as variable

capital used for producing anything is

meant capital. But interest is earned

only on the variable capital.


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Definition of InterestAccording to Seligman, Interest is the

return from the fund of the capital.According to J.M Keynes Interest is the

reward for parting with liquidity for aspecified period.

In simple words, Interest is a form ofincentive given by the borrower to thelender to make him part with his cashmoney.Or it can be defined as The income

obtained from that part of the capitalwhich is used for lending. It is the pricepaid by the borrower of money to itslender.


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Gross InterestIt is the amount paid by the borrower to a

lender as a return on capital borrowed.When we commonly talk of interest, it isgenerally gross interest.

Thus, gross interest is a wider term as itincludes in it the following component:

GI= Net Interest + Reward for risk taking +management + inconvenience.


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Time preference theoryAccording to this theory people like to

enjoy with money in present period. So tosay, present satisfaction is preferred tothe future satisfaction.

In this theory we say that rate of interest

is inversely related to the certainty ofincome in the future. If the future iscertain, time preference will be less and,therefore, rate of interest will be low.

Rate of interest is determined on the basisof this time preference. A man will changehis income flow by lending or borrowinguntil his time preference becomes equal tothe rate of interest.


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Classical Theory Of The Rate OfInterest

According to the classical theory of interest,

rate of interest is determined by theinteraction of the forces of demand andsupply of capital theory of interest.


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Demand for Capital

Capital is demanded for its productivity. Here it issaid marginal productivity of capital determinesthe demand for capital. If marginal productivity of

a capital unit is more, demand for capital will alsobe greater and vice versa

Law of diminishing returns also operates on themarginal productivity of capital.

If marginal productivity of capital is more than the

interest paid on it, it will be profitable to borrowmore capital. On the contrary, if the rate ofinterest exceeds marginal productivity of capital,the borrower can reduce his lose or raise hisprofits by borrowing less.


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Ultimately, equilibrium will prevail on that point

where rate of interest exceeds marginal

productivity of the capital.

Thus, we can conclude that there is an inverse

relationship between the rate of interest anddemand for capital. Demand for capital will be

more on a lower rate of interest and vice

versa.

This can well be made understood with the

graph shown


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r

r1

om m1

Demand for capital or investment

Rat e

of in

ter est

D

D


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Supply of CapitalSupply of capital results from savings. In

simple words, the money which is lent isthat portion of income which is not spenton consumption. So saving is the main

sources of capital. Level of savings dependsmainly upon two things:

(i) Capacity to save (ii) Willingness to save


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r1

r

M M1

S

S

Supply of capital or Saving

Rateof In

tere

st

O


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Determination of the EquilibriumRate of Interest

According to classical theory of interest isdetermined at the point where the demand forand supply of capital are equal. In otherwords, equilibrium of saving and investmentdetermines interest rate. This can beunderstood through a table


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Rate ofRate ofInterestInterest

Demand forDemand forCapital orCapital or

investmentinvestment

Supply ofSupply ofcapital savingcapital saving

10%10% 5050 9090

9%9% 6060 8080

8%8% 7070 7070

7%7% 8080 6060

6%6% 9090 5050

5%5% 100100 4040


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E1

D

DS

S

Q1

E

E2

Q

RATE

OF

INTERE

ST

DEMAND & SUPPLY OF CAPITAL/ SAVING & INTEREST


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Criticism of the theory

Based on the assumption of fullemployment.Assumption of long runSaving and investment equality

Monetary factors ignoredIndeterminate theorySaving is not the only source of capitalIt ignores demand for capital for

unproductive purpose.Fixed level of income


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The Neo-Classical Loanable fundstheory

This theory takes into consideration bothmonetary as well as real factors whiledetermining interest.

According to the theory not only waiting,time preference, saving and productivityetc. affect the rate of interest butmonetary factors like hoarding anddishoarding of money, credit creationthrough banks, consumption loans, alsoaffect the interest rate.


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Loanable Funds Theory

So this theory with broad definitions ofdemand and supply of loananble fundsdetermine the rate of interest.

The forces of demand and supply of

loanable funds can be explained.


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Investment Demand

Investment means expenditure of funds onbuilding new and fresh capital goods. Rateof interest is the cost of borrowing funds forinvestment.

A person will go on borrowing or demandingmoney for investment upto the point wherethe cost of borrowing i.e rate of interestbecomes equal to its marginal productivity

i.e income earned from its investment.


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Thus, there is an inverserelationship between the

rate of interest and demandfor funds for investment.


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Consumption Demand

People also demand loanable funds forconsumption purposes

This relationship is also inverse. In otherwords, higher is the rate of interest, lower

the demand for loanable funds forconsumption and vice versa.


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Demand for Hoarding

Hoarding means to keep money in idlecash. It is also interest elastic. At ahigher rate of interest people will like tohoard less and vice versa.

Thus , in order to derive demand curvefor loanable demand we have to add thethree demand curves i.e Investment

curve, Consumption Curve, HoardingCurve and thus, we get a final demandcurve for loanable funds


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Supply of Loanable Funds

There are four sources of supply ofloanable funds:

Savings

Dishoarding

Bank money

disinvestment


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Savings

Saving depends mainly upon two things:Size of income

Rate of interest

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