Theory of Interest

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Theory of Interest

• A brief overview of modern interest theories

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Knut Wicksell (1851-1926)
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• Born in Stockholm, Sweden, 1851
• Son of a successful businessman and real estate
  broker
• Orphan at the age of 15
• Mathematics and Physics
• 1887 Economics
• 1898 Interest and Prices
• 1916 Swedish government advisor on financial and
  banking issues
• main intellectual rival was the American
  economist Irving Fisher

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Interest and Prices

• natural rate of interest vs. money rate of
  interest

• real profit (r)
• MPK

• money market (i)

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Cumulative Process model

• MPK gt i ? I gt S ? M rises

Demand gt Supply ? prices rise
The demand for loans will continue
accumulating, and the banking system's deposit
creation continues indefinitely - with savings
never really catching up. Money supply will
expand endogenously without limit and prices will
also rise without end.
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What can end this process?

• Reserve Requirement Constraint

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Irving Fisher (1867-1947)
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• Born in New York, 1867
• Yale University
• 1888 B.A.
• 1891 Ph.D.
• Mathematics Economics
• 1930 The Theory of Interest

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The Theory of InterestAs determined by the
impatience to spend income and opportunity to
invest it.

• Income
• Capital
• Interest

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Income

• 3 stages
• Psychic income or enjoyment income
• Real income
• Money income or cost of living

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real income
The Thames below Westminsterabout 1871Oil on
canvas 47 x 72.5 cm.
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Money Income
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Capital
any asset that produces a flow of income over
time

• The value of any property, or rights to wealth,
  is its value as a source of income and is found
  by discounting that expected income (Fisher,
  1930, p.14).
• the value of capital is the present value of the
  flow of (net) income that the asset generates

Capital goods
Income
Income value
Capital value
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Rate of Interest

• capital value X rate of interest interest

1. the time preference people have for consuming
   today versus consumption at a later time, and
2. the expectation that income saved and invested
   today will yield greater income tomorrow
   capital produced today will generate greater
   future production than was required to construct
   the capital

IMPATIENCE
OPPORTUNITY
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Difference between Classical economists and
Irving Fisher

• According classical economists there are four
  sources of income
• Rent
• Wages
• Profits
• Interest

• Fisher treated interest not as a separate entity
  of income, but as sub-entity within each of the 3
  sources of income

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Other non-economic factors that influence rate of
interest

• Foresight - intelligence
• Self-control willingness
• Habit
• Life Expectancy
• The love of one's children
• Fashion

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Fisher, Irving. The Nature of Capital and Income.
New York The Macmillan Company, 1906.Octavo,
1st edition in original green cloth.
1600.Source http//www.manhattanrarebooks.com/f
isher.htm
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John Maynard Keynes (1883-1946)
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• Born in Cambridge, 1883
• King's College, Cambridge
• Mathematics in 1905
• Alfred Marshall and Arthur Pigou
• 1936 General Theory
• 1942 was made a lord
• 1944 Bretton Woods Conference
• April 21, 1946 passed away

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General Theory

• Liquidity-preference

Wealth is allocated between liquid and illiquid
assets
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• Thus the rate of interest at any time, being
  the reward for parting with liquidity, is a
  measure of the unwillingness of those who possess
  money to part with their liquid control over it.
  The rate of interest is not the price which
  brings into equilibrium the demand for resources
  to invest with the readiness to abstain from
  present consumption. It is the price which
  equilibrates the desire to hold wealth in the
  form of cash with the available quantity of cash
  which implies that if the rate of interest were
  lower, i.e. if the reward for parting with cash
  were diminished, the aggregate amount of cash
  which the public would wish to hold would exceed
  the available supply, and that if the rate of
  interest were raised, there would be a surplus of
  cash which no one would be willing to hold.
  (Keynes, 1936).

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Money Demand Theory

• People hold money for three reasons

• Transaction Motive
• Precaution Motive
• Speculation Motive

Uncertainty
Expectation
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On expectation

• If E(?i) gt 0 ? Md gt 0
• If E(?i) lt 0 ? Md lt 0

Md (E(?i))
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Interest Rate is a function of money demand and
money supply it is a monetary factor

• i i (Md, Ms)

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Sir John Hicks (1904 - 1989)
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Sir John Hicks

• Born in 1904 at Warwick, England
• Mathematics
• Clifton College (1917-22)
• Balliol College, Oxford (1922-26)
• 1937 IS-LM model

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IS-LM model

• Based on John M. Keyness General Theory
• All equilibria in both commodity and money markets

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• IS curve Y f(i) ? equality of S and I
• LM curve i f(Y) ? equality of Ms and Md

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In 1982 Hicks rejected this model because
although it is a very useful apparatus to
understanding Keynes General Theory but it lacks
one very essential thing that Keynes already knew
Uncertainty