Interest
Interest, Gross Interest and Net Interest
Interest
In ordinary language, interest refers to the excess amount, which is paid by the borrower above the amount borrowed after a given period of time usually a year to the lender at an agreed percentage. In economics the term interest refers to a return on capital only. Samuelson defines interest as
“The market rate of interest is that percentage return per year which has to be paid on any safe lone of money, which has to be yielded by any safe bond or other type of security, and which has to be earned on the value of any capital asset in any competitive market where are there are no risks or where all risks have already been taken care by special premium payments to protect against risk”.
It therefore can be said that interest in the price of services of capital in the production of wealth.
Gross Interest
The total amount which a creditor charges from a debtor by way of interest is really Gross interest. It includes the services payments of the capital and the cost of capital. The gross interest means the total amount which a debtor pays to the creditor and their Interest includes certain costs and expanses. Gross interest is composed of certain elements such as insurance against risk, return for inconvenience, wages of management etc.
Net Interest
Net interest is the amount, which is paid for the use of capital only as a factor of production. Net interest is rather the price of the productivity of capital. It is equal to the gross interest minus the cost of lending. Net interest is generally equals to the channels of lending.
Constituents of Gross Interest
Gross interest consist of the following elements:
1. Insurance Against Risk
A creditor knows by his experience that some of his debtor will not repay. Thus he sees a risk in lending. This lose which is likely to be faced by this non-payment is equally distributed over the debtors which are not going to fail in making payment s back. Thus good debtors have to pay for the bad once. Every debtor is good debtor is charged a certain percentage as an insurance against risk.
2. Return for Inconvenience
The inconvenience to the lender is mainly of two types
a. He may have to borrow money and pay interest himself when he would need money in some future time.
b. He may get money back when he may not find some lucrative place to invest it and so his money may remain idol and suffer loss.
In order to avoid the above two situations the creditor often charge something extra over and above pure interest.
3. Wages of Management
The creditors do a lot of work for their money lending business. They have to keep accounts, frequently visit the debtors reminding them about the loans etc. It seems to be their whole time job. Similarly in this business they would have lost the chance of making money by doing something else. This lose also has to be borne by the creditor.
Why Interest is paid?
Interest is paid for the following reasons:
1. Capital is Productive
Capital improves the quality and increases the quantity of out put with in a given time. It means that capital contributes in the national dividend and therefore it is demanded and paid as a share of capital in the national dividend.
2. Capital Involves Lending
Capital has a lending cost behind it. This why interest is demanded and paid to cover the lending cost.
3. Capital is Capable of Alternative Uses
Capital is a secure commodity so it commands price. Therefore interest is demanded because of scarcity of capital.
4. Capital Increases the Efficiency of Land and Labour
Capital increases the efficiency of land and labour and reduces the cost per unit of out put. Interest is therefore demanded and paid because it reduces cost per unit and also brings out a standard in the production.
5. Capital is Mobile
Capital is mobile and it moves easily from one channel of production to another within a country. Sometimes it also moves out side the country. Interest is demanded because of its productivity and scarcity due to mobility and is therefore paid.
6. Capital is a Result of Saving + Lending
Both saving and lending are painful in the sense that saving involves sacrifice of present consumption and lending. It involves the risk of bad debts and it also involves the risk for long term waiting for the amount to be returned. Interest is demanded for such a sacrifice and inconvenience.
7. Capital Serves as a Substitute for Land and Labour
Interest is demanded for the service of capital which substitutes land and labour and is accordingly paid.
Liquidity Preference Theory
Concept of the Theory
The liquidity preference theory was first enunciated by Lord Keynes. This theory is based on consumption and saving of an individual given a certain amount of income. According to Keynes an individual has a limited (given) amount of income which require two decisions on his part
a. How much he has to consume? And
b. How much he has to save?
The decision regarding consumption is called propensity to consume in the words of Keynes, which he spends, on consuming goods. After spending the individual has a certain proportion of his income left with him, which is his saving. Again he has to decide that weather he has to hold his saving in the form of cash or in the form of capital for earning interest. This is what Keynes has called liquidity preference.The smaller the desire to lend, the higher the liquidity preference.
Factors Governing Liquidity Preference
The liquidity preference of a particular person depends on a number of conditions. These may be:
1. Transaction Motive
The transaction motive relates to the demand for money or 5the need for cash resulting due to an individual’s current personal and business transaction and exchanges.
2. Precautionary Motive
Precautionary motive refers to the desire of the people to hold cash or sustain the saving for any unseen emergencies.
3. Speculative Motive
It relates to hold cash or resources in liquid form in order to take advantage of the market movements regarding the future changes in prices.
According to Keynes most of the people save money with speculative motive.
Determination of the Rate Interest
In the Keynesian world the demand for money or the liquidity preference and the supply of money determine the rate of interest. It is infect the liquidity preference for speculative motive, which along with the quality of money determines the rate of interest.
Criticism
The liquidity preference theory is often criticized on the following grounds:
1. The rate of interest is not a purely monetary phenomenon. One of the major criticisms made on this theory is that the rate of interest is not purely monetary phenomenon as real forces like productivity of capital etc also play an important role in the determination of the rate of interest.
2. Liquidity preference is not the only factor governing. The agreement for this statement was that there are several other factors that influence the rate of interest by the demand for and supply of investible funds
3. Keynis ignores saving or waiting as a source or means of investible fund
4. Keynis theory explains interest in the short run only and also does not explain the existence of different rates of interest prevailing in the market at the same time.
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