Lesson-19:

Modern Theory of Interest Rate Determination

Objectives:

After studying this lesson, you will be able to understood,

 Definition of Interest rate

 Determinants of Interest rate

 Derivation of IS and LM Curves

 Simultaneous determination of Interest rate and Income

19.1 Introduction

19.2 Modern Theory of Interest rate determination

A) Derivation IS Curve
B) Derivation of LM Curve
C) Determination of Interest rate in IS-LM Model

19.3 Summary

19.4 Glossary

19.5 Model questions

19.6 Further Readings

19.1 Introduction:

The rate of interest is the price paid by barrowers to induce the holders of savings
amount. According to Keynes, interest is paid as a reward to those who part with
their present consumption. In fact, in an economy there are a number of rates of
interest prevailing at a time. They are: Real rate of Interest, Money rate of interest,
Equilibrium market rate of interest and the natural rate of interest. The real rate of
interest is one which equates intended investment and intended saving. Money rate
of interest that equates the demand for supply of money. The equilibrium market
rate of interest which presents equilibrium between real rate of interest and the
money rate of interest. The natural rate of interest is one which equates intended
investment and intended saving at full employment level of income.

As you aware, various schools of economic thought have their own view on
determination of interest rate. For example, Classical view is that the rate of
interest is determined by the changes in demand for investment and supply of
savings. It means the intersection point of investment and savings curve is known
as interest rate determining point. Neo-classical of the opinion that the demand for
loanable funds and supply of loanable funds determine the interest rate. The point
of intersection of demand for and supply of Loanable funds curve is interest rate
determining point. While JM Keynes expressed that the demand for supply of
money will be the determinant factor of interest rate.
Now let us try to understand the determinant factors of interest rate as per the
modern theory of interest rate determination.

19.2 Modern Theory of Interest rate determination:

Classical theory of interest includes only the real variables as determinants of

interest rate. They are savings and investment or demand for capital and supply of
capital. Neo-Classical theory of interest identified partly real variables and partly
monetary variables as determinants of interest rate while Keynes theory of interest
rate mentioned that the monetary variable only determine the interest rate. Above
stated models are not comprehensive models thus there is a need to understand the
determinants of interest rate in which both real and monetary variables used in its
explanation.

The modern theory of interest integrates all these factors- real and monetary
variables- at various levels of income. It thus synthesizes both the loanable funds
theory and liquidity preference theory. The four variables viz saving, Investment.
Liquidity Preference and quantity of money have been combined to provide two
new curves, the IS curves and LM curve. The IS represents the product or goods
market and LM represents Money Market.
A) Derivation of IS Curve:

Since saving is an increasing function of income, and investment is decreasing

function of rate of interest, we can compute investment demand schedule. Given
the investment demand schedule, the saving schedule gives different points of
equilibrium between saving and investment, indicating different rates of interest
corresponding to different levels of income. The line joining these points is the IS
Curve. IS Curve thus is a locus of points representing various combinations of
income levels and interest rates at which aggregate real savings and aggregate real
investments are in equilibrium

In figure (A), Y, Y1, Y2, Y3, are showing income levels and S, S1, S2, S3, are
saving levels. At Income level Y the equilibrium between saving and investment is
established at 4 percent rate of interest: at Y1 Income level, the equilibrium
between saving and investment is established at 3 percent rate of interest and so on.
Figure (B) represents, the equilibrium rate of interest have been connected with
their corresponding income levels and the curve so obtained is the IS Curve.

B) Derivation of LM Curve:
We derive LP Schedule from JM Keynes theory of Liquidity Preference. These
together with the supply of money schedules as LM Curve. The supply of money is
fixed (short run) and interest inelastic. The Liquidity Preference is income elastic.
Thus the LM curve is the locus of points representing combinations of interest
rates and income levels at which the demand for and supply of money are equal, as
shown in the below table 19.2

In figure above, LY, L1Y1, L2Y2 and L3Y3 are the Liquidity Preference curves of
Income levels Y, Y1, Y2, and Y3 respectively. MS is the money supply curve
showing fixed money supply OM. At Y income level the equilibrium between the
demand for and supply of money is established at one percent rate of interest, at
Y1 income level it is established at 2 percent rate of interest and so on. By
connecting the various equilibrium rate of interest with the corresponding income
levels, obtain the LM Curve.
C) Determination of Rate of Interest: ( IS- LM Model)
Modern theory of interest rate was developed by Hicks and Hansen. In their theory
they have integrated both the Real and Monetary variables for simultaneous
determination of rate of interest and Income. Otherwise what we call it as
equilibrium in both the markets i.e., Goods market and Money market. According
them, it is at the point of intersection of IS and LM curves that both the equilibrium
rate of interest and equilibrium level of income are determined. It means one side
there will be equilibrium between savings and investment and other side
equilibrium between demand for and supply of money. Simultaneous
determination interest rate and income levels presented in the below figure 19.3.
IS and LM curves intersect each other at point E. the equilibrium of rate of interest
is OR and the equilibrium income level is OY. OR and OY is the one combination
of rate of interest and income at which both the real and money markets are in
equilibrium.

19. 3 Summary

Theories of interest rate developed by various economic schools of thought.

Among the different theories, modern theory of interest rate is refined and
comprehensive model. Classical model has used only Real variables and attained
equilibrium in Goods market where as, Neo classical model used partly real and
partly monetary variables and had explained the rate of interest determination. JM
Keynes was presented by considering only monetary variables excluded real
variables like demand for and supply of money as determinants of rate of interest.
But the modern theory of interest considered both real and monetary variables and
obtain simultaneous determination of interest rate and income levels in both goods
and money market.

19.4 Glossary
Interest rate
Real rate of interest
Natural rate of interest
Equilibrium market rate of interest
Loanable funds
Demand for money
Supply of money
Real variables
Monetary variables

19.5 Model Questions

Short answer Questions

1. What are the views of classical on rate of interest

2. Distinguish the goods and money market
Essay answer Questions
1. Discuss how do we derive IS and LM Curves
2. Critically examine how are rate of interest and Income determined
simultaneously in IS-LM Model
3. “Both the Classical and Keynesian theories of interest rate are
indeterminate”--Discuss

19.6 Further Readings

Hajela TN : Macro economic theory, Ane’s Books Private Limite, New

–Delhi 2009
Ackley, G : Macro Economics
Hansen, AH : Monetary and fiscal policy p 71
Klein, LR : The Keynesian Revolution, pp 118-120
De Scltovszky P : “A Study of Interest and Capital”, Economics New Series
Vol. VII, 1940, p 293