Interest Rate Theory

Interest rates refer to the costs that individuals incur when they borrow funds from the financial institutions. It is the price paid when one borrows funds for personal or business use. On the other hand, it is also the reward that is given to those who lend money, through the financial institutions. The people who save money and those who borrow are linked together by the financial institutions that ensure that loans are sold to the customers and rewards are given to those who have saved their money. There are many factors that influence the level of interest rates in an economy. Various theories have been put forward by various theorists, and the aim of this paper is to compare these theories. There are three theories compared in this case.

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The classical theory of interest rates explains that the demand and supply for capital is what determines interest rates at a particular time. From the demand side, businesses and investors borrow up to a point where the marginal product of the capital is equal to cost they pay for the loans. On the other hand, people save as interest rise since the rewards from their savings increase and they have more cash to consume in future. The point where the demand for capital and supply for the same is the same is equal to the interest rates in an economy.

Loan-able funds theory or neoclassical theory also explains the interest rates in an economy. This theory argues that interest rates are achieved at an equilibrium point where the demand for loan-able funds is equal to the supply. The difference with the arguments by the classical theory is that loan-able funds also originate from the central bank, which supplies money in the economy. On the other hand, it recognizes that people tend to hoard money for a short period, and such money may not be available for loans.

The Keynesian theory explains that the demand and supply for money is what determines the interest rates. While people hoard money for transactional and precautionary purposes, the speculative purpose is what specifically influences interest rates. Since money is the most liquid asset, people hoard it if the reward (interest) is very low. As the rewards increase, people invest in bonds and as the bond prices rise, interest decrease, and this makes people sell bonds because the benefits are low. This means that there is a relationship between interest rates and demand for money. The supply for money is determined by central banks, and is fixed. At a point where the demand for money is equal to the supply, the equilibrium is the prevailing interest rates in the economy.

In conclusion, the three theories are different, but explain the interest rates phenomena in an economy. While the classical theory is based on the supply and demand for capital to predict interest rates, neoclassical theory advances the classical theory by arguing that the monetary policies also contribute to the interest rates in the economy. On the other hand, Keynes suggests that the demand for money can be categorized into precautionary, precautionary and speculative demand. The supply for money is determined by the central bank, and the equilibrium between the demand for money and the supply is what determines the interest rates in an economy.