Theories of Interest: Caiib Paper 1 (Module A), Unit 4
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So, here we are providing “Unit 4: Theories of Interest” of “Module A: Economic Analysis” from “Paper 1: Advanced Bank Management (ABM)”.
The Article is Caiib Unit 4: Theories of Interest
Interest is a payment made by a borrower for the use of a sum of money for a period of time.
Three elements can be distinguished in interest:
- Payment for the risk involved in making the loan
- Payment for the trouble involved
- Pure interest, i.e. a payment for the use of money.
Keynes’ Liquidity Preference Theory of Rate of Interest
- J M Keynes in his book “The General Theory of Employment, Interest and Money” views that the rate of interest is purely monetary phenomenon and is determined by Demand for money and supply of money.
- J M Keynes theory is known as “Liquidity Preference Theory”
- Rate of interest and bond prices are inversely related.
- Money Demand curve follows from above that quantity of money demanded increases with the fall in the rate of interest or with the increase in level of nominal income.
- The rate of interest is determined by demand for money (Liquidity Preference) and supply of money – JM Kenes.
The position of money demand curve depends upon two factors:
- The level of nominal income and
- The expectation about the changes in bond prices in the future which implies change in rate of interest in future.
IS and LM curves Theory promulgated by Sir Hon Richard Hicks and Alvin Hansen
Renowned Economists, Sir John Richard Hicks and Alvin Hansen, have brought about a synthesis be-tween the classical and Keynes’ theories of interest and have thereby succeeded in propounding an adequate and determinate theory of interest. This involves 3 steps:
- Using Classical Theory to derive a curve called IS Curve.
- Using Keynes’s Theory to derive a curve called LM Curve.
- Combining IS and LM Curves.
The IS curve and the LM curve relate the two variables
- Income and
- the rate of interest
LM= Liquidity preference and Money supply equilibrium. LM curve is derived from Kenes Liquidity preference theory of interest.
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