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As per Marshall, 'Interest is the price for the use of capital in a market'. In other words, interest is that part of national income which is paid to capitalists as a reward of the services of capital. However, in Keynes opinion, interest is a reward for parting with liquidity for a specified period.
Three distinct elements can be distinguished in interest:
a) Reward for the risk involved in making the loan;
b) Payment for the trouble involved;
c) Pure interest, i.e., price of the capital.
GROSS INTEREST = Net interest + reward for risk + reward for inconvenience + reward for pains + reward for management.
NET INTEREST = (Gross Interest)— (Reward for Risk + Reward for inconvenience + Reward for Pains + reward for management).
a) Difference is risk perception.
b) Difference on account of credit rating of borrower.
c) Difference in maturity period of loan.
d) Purpose and end use of the loan.
f) Nature of the primary and collateral security.
g) Quality of third party guarantee.
A) Prof. Senior: Abstinence. heory of Interest: "Interest is the reward for waiting and abstinence".
B) Fishers Time Preference Theory of Interest: Interest is the reward paid to induce people to postpone their present consumption and to
lend their money.
C) Keynes Liquidity Preference Theory of Interest: Prof J.M. Keynes in his book, the General Theory of Employment, Interest and Money, has
viewed rate of interest as a purely monetary phenomenon and is determined by demard for money and supply of money. According to this
theory, rate of interest is determined by liquidity preference, i.e., demand of money on one side and the supply of money on the other.
Demand of money means the demand for keeping money in liquid form. Thus, demand of money means liquidity preference. The term
liquidity preference means the habit cf persons to keep their money in liquid form. When a person gets his income, he has to take two
important decisions:
a) How much to spend and how much to save, and
b) How much to save in liquid form and how much to save in non-liquid form.
The term liquid form means to keep money in the form of ready purchasing power i.e. cash or gold or any such way as can readily be
converted into cash. The term non-liquid form means to invest money in iong term securities and capital goods
Keynes explained interest in terms of purely monetary forces. Keynes assumed a simplified economy where there are two assets which
people can keep in their portfolio balance. These two assets are:
a) Money in the form of currency and current deposits in the banks which earn no interest,
b) According to Keynes, rate of interest and bond prices are inversely rlated. When bond prices go up, rate of interest rises and vice versa.
The demand for money by the people depends upon how they decide to balance their portfolios between money and
bonds. This decision about portfolio bal?nre ran he influenced by two factors.
First, the higher the level of nominal income in a two-asset economy, more the money people would want to hold in their portfolio balance.
This is because of transactions motive according to which at the higher level of nominal income, the purchases by the people of goods and services in their daily life will be relatively larger, which require more money to be kept for transactions purposes.
Second, the higher the nominal rate of interest, the lower the demand for money for speculative motive. This is firstly 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 ne fall in the future causing capital losses to them.
Prof. Keynes cites three motives to explain why people prefer to keep their money in liquid form. These motives are as under
1.Transactional Motives: People keep a part of their income in liquid form so that they can pay their regular expenses. Liquidity preference
for transactional motives will depend upon the size of income, time of receipt and number of transactions.
2.Precautionary Motives: People keep some part of income to provide for contingencies, such as illness, accident, unemployment etc.
Liquidity preference for such motives depends upon the level of income, size of family, living conditions and habit of individuals etc.
3.Speculative Motives: Some persons like to keep their money in liquid form for speculative purposes also so that they can get the advantage of changes in the rate of interest.Thus, Demand of money = Transactional motive + Precautionary motive + Speculative motive.
Liquidity preference depends upon the income and rate of interest. There is an inverse relationship between rate of interest and demand for money (liquidity preference). If the rate of interest is high, liquidity preference will be less because the people would like to invest more and more amount. If the rate of interest is low, liquidity preference will be more because the people would like to keep the money with themselves.

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