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Organizer: Rajendra Adhikari Presenter Anish Ojha

The document summarizes two theories of interest rate determination: the loanable funds theory and liquidity preference theory. Under the loanable funds theory, the interest rate is determined by the interaction between demand for and supply of loanable funds. The liquidity preference theory, developed by Keynes, states that the interest rate is determined by the interaction between demand for money, or liquidity preference, and the supply of money, which is determined by central banks. Both theories use supply and demand diagrams to show how equilibrium interest rates are established in financial markets.

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44 views11 pages

Organizer: Rajendra Adhikari Presenter Anish Ojha

The document summarizes two theories of interest rate determination: the loanable funds theory and liquidity preference theory. Under the loanable funds theory, the interest rate is determined by the interaction between demand for and supply of loanable funds. The liquidity preference theory, developed by Keynes, states that the interest rate is determined by the interaction between demand for money, or liquidity preference, and the supply of money, which is determined by central banks. Both theories use supply and demand diagrams to show how equilibrium interest rates are established in financial markets.

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anish ojha
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ORGANIZER: RAJENDRA ADHIKARI

PRESENTER; ANISH OJHA


Loanable fund theory of interest

 This is also known as neo-classical theory of interest. According to this theory, the rate of interest
is determined by the interaction between demand for loanable fund and supply of loanable fund.
 For equilibrium rate of interest,
 Demand for loanable fund
 Supply of loanable fund

 The point of intersection between and determines equilibrium rate of interest.

 The loanable fund is demand for following purposes.

a) Demand for consumption (C)


b) Demand for investment (I)
c) Demand for hoarding (H)
Supply of Loanable Fund

 The sources of loanable fund are the supply of loanable fund. The following are the
sources of loanable fund.

a) Saving
b) Disinvestment
c) Dishoarding
d) Bank Money


Determination rate of interest

 The determination of rate of interest under Loanable Fund Theory can be explained with
the help of following diagram.
 Demand of loanable fund = supply of loanable fund
 I+C+H=S+B+DH+DI
 (I-DI)+(H-DH)=S+B+C

Net investment+Net hoarding=Net saving+


bank credit
Liquidity Preference Theory of Interest

 Liquidity Preference Theory of Interest was developed by JM Keynes. Money possesses the characteristics of liquidity.
 People demand money due to the characteristic of liquidity in money. So, liquidity preference means demand for money.
 According to JM Keynes, interest rate is determined by the intersection between demand for money (liquidity preference) and supply of
money.
A) Demand for Money ( Liquidity Preference) [
 According to Keynes, money is demand for three motives:
 Transaction demand for money

 Precautionary demand for money =


 In linear form, the can be expressed as:

 Where, proportion of the income held in the form of cash


 Speculative demand for money; The speculative motive relates to the desire of people to hold
cash in order to take the advantages of market movement regarding the future change in rate of
interest or bond price. Bond is a fixed return bearing security whose price is inversely related to
interest rate. In other words, there is inverse relationship between interest rate and bond price.

 In algebraic form, (2)

 Autonomous part of speculative demand, independent of interest rate.


Liquidity Trap

 If rate of interest continues to fall, demand for money for speculative motive goes on
rising. It means, the speculative demand for money increases with the fall in interest rate.
When interest rate becomes minimum, beyond which there is no further fall in interest
rate, all the money is held by the people. So, at very low rate of interest, speculative
demand is perfectly elastic. The speculative demand at very low rate of interest is defined
as ‘Liquidity Trap’. The liquidity trap is the situation in which speculative demand is
perfectly elastic at very low rate of interest. The liquidity is in trap in this situation.
Total money demand

 The transaction and precautionary demand is interest-inelastic and speculative demand


is interest elastic. In diagram, the money demand curve of interest-inelastic is parallel to
Y-axis, the interest-elastic part will be downward sloping and liquidity trap is perfectly
elastic as shown by the following figure.
b) Supply of Money

 . According to Keynes, the supply of money is determined by the policy of central bank
and it is given or constant.
 So, supply of money is given as:

 The supply of money is interest-inelastic. So, the money supply curve is perfectly inelastic
to interest rate. The money supply curve is a vertical straight line.
Determination of Interest Rate

 The interest rate, according to Keynes, is determined by the intersection between money
demand curve (LP curve) and money supply curve. The point of intersection between
these two curves determines equilibrium rate of interest. At equilibrium interest rate,
money demand equals money supply. This can be shown in the following figure

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