Theory of Interest

A brief overview of modern interest

theories

Knut Wicksell (1851-1926)

 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

Interest and Prices

natural rate of interest

real profit (r)

MPK

vs. money rate of interest

money market (i)

Cumulative Process model

MPK > i I > S M rises

Demand > 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.

What can end this process?

Reserve Requirement Constraint

Irving Fisher (1867-1947)

Born in New York, 1867

Yale University

1888: B.A.
1891: Ph.D.

Mathematics & Economics

1930: The Theory of Interest

The Theory of Interest:

As determined by the
impatience to spend income
and
opportunity to invest it.

Income
Capital
Interest

Income

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

real income

The Thames below Westminster

about 1871
Oil on canvas 47 x 72.5 cm.

Money Income

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

Capital value

Income value

Rate of Interest

capital value X rate of interest = interest

IMPATIENCE

OPPORTUNITY

(a) the time preference people have for

consuming today versus
consumption at a later time, and
(b)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

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

Other non-economic factors that

influence rate of interest:

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

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/fisher.htm

John Maynard Keynes (18831946)

 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

General Theory
Liquidity-preference
Financial wealth

Illiquid assets

Liquid assets

Wealth is allocated between liquid and illiquid assets

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).

Money Demand Theory

People hold money for three reasons:

Transaction Motive
Precaution Motive
Speculation Motive

Uncertainty

Expectatio
n

On expectation

If E(i) > 0 Md > 0

If E(i) < 0 Md < 0

Md (E(i))

Interest Rate is a function of money demand and

money supply; it is a monetary factor
i* = i (Md, Ms)

Sir John Hicks (1904 - 1989)

Sir John Hicks

Born in 1904 at Warwick, England

Mathematics
Clifton College (1917-22)
Balliol College, Oxford (1922-26)
1937: IS-LM model

IS-LM model
Based

on John M. Keyness General Theory

All equilibria in both commodity and money
markets

IS curve: Y = f(i) equality of S and I

LM curve: i = f(Y) equality of Ms and Md

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