ADVERTISEMENTS:
Some of the theories of interest along with its criticisms are: 1. Classical Theory of Interest 2. Loanable Funds Theory of Interest 3. Liquidity Preference Theory of Interest 4. Modern Theory of Interest 5. Expectations Theory 6. Liquidity Premium Theory 7. Market Segmentation Theory .
1. Classical Theory of Interest:
The theory is also called saving investment theory of interest or demand and supply theory of interest. The theory was propounded and developed by classical economists, namely, Marshall, Pigou, Cassels, Walras, Tausing and Knight.
Demand for Capital:
ADVERTISEMENTS:
The demand for capital is based on its productivity. The demand consists of consumption and productive purposes. Capital is demanded because of its productivity. Marginal productivity of capital goes on decreasing because of operation of law of variable proportions. A producer demands for capital or saving and reward is paid for the use of capital or saving in the form of interest.
An entrepreneur employs capital to the point where the role of interest is equal to the productivity of capital. There is inverse relationship between the role of interest and demand for capital. Higher the rate of interest lower will be the demand for capital and lower the rate of interest higher will be the demand for capital.
It can be shown from the following diagram:
The diagram shows II is the investment schedule or demand for capital. Rate of interest and demand for capital are shown on OY-axis and OX-axis respectively. When the rate of interest is OR the demand for capital is OQ and when interest increases the demand for capital decreases from OQ to OQ1. Thus, there is inverse relationship between the rate of interest and the demand for capital.
ADVERTISEMENTS:
Supply of Capital:
The supply of capital depends upon the savings in the society. Savings are from individuals, firms and government. Savings are affected by several factors, namely, level of income, standard of living, attachment to family, law and order, security of life and property, political stability, etc. There is a direct relationship between the rate of interest and supply of capital or saving.
Higher the rate of interest higher will be the rate of supply of capital and lower the rate of interest lower will be the supply of capital. The supply of capital or saving schedule and the rate of interest can be seen from Diagram 2.
Rate of in interest is shown on OY-axis arts supply of capital or savings on OX-axis respectively. SS is the saving schedule or supply of capital. When rate of interest is OR the supply of capital is OQ. When it increases form OR to OR1 the supply of capital or savings also increases from OQ to OQ1. It means there is direct relationship between rate of interest and supply of capital.
Determination of Rate of Interest:
According to the classical theory of interest the rate of interest will be determined at the point where the supply schedule (SS) and investment schedule (II) intersects each other.
It is shown in the following diagram:
The point of equilibrium is at E where the investment is equal to savings. The rate of interest is OR and the demand for and supply of capital are equal to OQ.
Criticism of the Theory:
The classical theory of interest has been criticised on the following grounds:
(1) The theory assumes that savings and investment are brought in equilibrium through the rate of interest. But in actual practice we see that it is not the rate of interest but it is the level of income which brings equilibrium between saving and investment.
ADVERTISEMENTS:
(2) Savings and investment are not interest elastic. Professor J.M. Keynes has criticised that savings and investment are not so interest elastic as assumed by the classical economists. Savings depend on the level of income and the investment depends on the productivity of capital. If the marginal productivity of capital is high the demand for capital will be high even at a higher rate of interest.
(3) The theory ignores the effects of investment on income level. Classical economists have assumed that the level of income remains constant but in actual practice we see that the change in investment also affects the level of income. Increase in investment increases employment and income in the society will further increase savings. Decrease in investment will also decrease employment and income and thereby savings will also decrease.
(4) The theory is based on unrealistic assumption. Full employment, perfect competition and supply create its own demand. Such assumptions are not found in real world.
(5) The theory ignores monetary factors while determining the rate of interest. It emphasises on the marginal productivity and economy while determining the rate of interest which are real factors. It has ignored the money and credit factors which also play important role in interest determination.
(6) Savings are not only based on current income but they are also generated from dishoarding, bank credit and disinvestment. These elements have not been discussed by the theory.
(7) There is no equality between natural rate of interest and market rate of interest. Professor J.M. Keynes has pointed out that the expansion or contraction of credit can bring the change in market rate of interest and thereby the natural rate of interest is also affected.
(8) Saving and investment schedules have been assumed to be independent by the theory. But in actual practice we see that they are not independent. According to Professor Keynes, when the rate of interest affects investment it will also affect level of income and thereby savings are also affected. Contrary to it, the level of investment, income and savings are also affected. Thus, the explanation of the theory is not correct and realistic.
2. Loanable Funds Theory of Interest:
The theory was propounded by Wicksell, Ohlin Robinson and A.C. Pigou. It is an improvement on the classical theory of interest. It is also called neo-classical theory of interest.
According to this theory the rate of interest is determined by the demand for loanable funds and the supply of loanable funds. There are several factors affecting the demand for and supply of loanable funds.
Demand for Loanable Funds:
There are various sides from which the loanable funds are demanded.
Classical economists emphasised the demand for investment only but there are several purposes for which funds are demanded as given below:
(1) Investment Demand:
One of the important elements for the demand for loanable funds is investment. Investment is needed for capital goods and other infrastructures. Interest is the cost for the demand for loanable funds. An entrepreneur invests capital to that point where the rate of interest is equal to the marginal productivity of capital as with the increase in capital investment the marginal productivity of capital declines.
(2) Dissaving:
When expenditure is more than the current income then it is called dissaving. More expenditure on consumption is done than the current income by the people will lead to negative savings. Loanable funds are demanded by such consumers who are spending more than their current incomes.
Durable items like refrigerator, car, scooter, T.V. and construction of houses are needed for which such funds are demanded. Lower the rate of interest higher will be the demand for loanable funds and contrary to it, on the higher rate of interest they will be discouraged to borrow.
(3) Demand for Hoarding:
People would like to hoard money or wealth and they demand for loanable funds. Such hoardings can be used for investment in shares and debentures. Lower the rate of interest higher will be the demand for such loanable funds and vice versa.
Thus the demand for loanable funds can be shown by the following diagram:
DD is the demand for loanable hinds which is shown on OX-axis while rate of interest is shown on OY-axis. When the rate of interest is OR the demand for loanable funds is OQ. When the rate of interest decreases from OR to OR1 the demand increases from OQ to O1. It means there is inverse relationship between the rate of interest and demand for loanable funds.
Supply of Loanable Funds:
There are various sources of supply of loanable funds as given below:
(1) Saving:
The most important source of supply of loanable funds is saving. Saving is the difference between the income and consumption. Saving depend on the level of income of individuals, households and the government. There is direct relationship between the rate of interest and rate of savings. Higher the rate of interest people will save more and vice versa.
(2) Dishoarding:
When hoarded money or wealth is used for the consumption and investment purposes it is called dishoarding. When rate of interest is high people will be encouraged to dishoard their savings and it will increase the supply of loanable funds. Contrary to it, people will not use dishoarding and the supply of loanable funds will not increase.
(3) Bank Credit:
The supply of loanable funds is also increased by expansion or contraction of bank credit. Higher the rate of interest more will be the bank credit available and loanable funds will increase in supply.
(4) Disinvestment:
Disinvestment means the withdrawal of the amount invested by the entrepreneurs and investors. When the disinvestment takes place the supply of loanable funds will increase and it will be only possible when the rate of interest is high. If the rate of return on investment is low then the invested capital is withdrawn and it will increase the supply of loanable funds.
Thus, the supply of loanable funds and the rate of interest have direct relationship as shown in the diagram:
SS is the supply of loanable funds and the rate of interest and the supply of such funds have direct relationship. It the rate of interest is OR the supply of loanable funds is OQ. With the increase in the rate of interest from OR to OR1 the supply of loanable funds increases from OQ to OQ1.
Determination of the Rate of Interest:
The equilibrium rate of interest will be determined at the point where the demand curve for loanable funds cuts the supply curve of loanable funds as shown in the diagram given below-
Demand for loanable funds (DD) and supply of loanable funds (SS) are shown on OX-axis while the rate of interest is shown on OY- axis. The point of equilibrium is at E where the rate of interest is OR and the demand for loanable funds is equal to its supply (OQ).
Criticism of the Theory:
The theory of loanable funds has been criticised on the following grounds:
(1) Wrong and Unrealistic Concepts:
The theory has taken a wrong and unrealistic concept of hoarding. The quantity of money does not increase or decrease through the process of hoarding as pointed out by Professor J.M. Keynes.
(2) Saving are not Highly Interest Elastic:
The theory explains that savings are highly interest elastic. But in practice we see that without any change in the rate of interest people save more on account of family attachment, foresightedness and high levels of income.
(3) The Level of Income:
It does not remain constant as assumed by the theory. There is always change in the level of income on account of change in savings and investment. Lower interest rate encourages investment and it increases income of the people in the society.
(4) Combination of Monetary and Non-Monetary Factor:
The theory has combined monetary and non-monetary factors while determining the rate of interest. Saving and investment are real factors while bank credit and dishoarding are monetary factors. They have been combined without changing the level of income. This sort of combination makes the theory more unrealistic and imaginary.
3. Liquidity Preference Theory of Interest:
J.M. Keynes has propounded the theory of interest known as the liquidity preference theory. According to this theory, “Interest is the reward for parting with liquidity for a specific period.” In other words, it can be said that interest is the reward for parting with liquidity.
Professor J.M. Keynes has rightly pointed out, “It is the price which equilibrate the desire to hold wealth in the form of cash with the available quantity of cash.” In short period the supply of money remains constant whiles the demand for money keeps on changing.
According to liquidity preference theory of interest the rate of interest is determined by the demand for liquidity and supply of liquidity. The theory is also called the monetary theory of interest. J.M. Keynes believed that interest is not the reward for hoarding but it is the reward for parting with liquidity.
Meaning of Liquidity Preference:
Before studying the determination of rate of interest we should know the meaning and motives of liquidity preference.
Wealth is generally preferred to be kept in cash in any society. There are various forms in which income and wealth are kept in the most liquid form of wealth and income in cash or money. If wealth or income is kept in cash it can be used for any purpose and there is no difficulty and it will be a facility to use the income at desire. Income or wealth can be kept in the form of land, building, shares, debentures, government securities, etc., but it cannot be used in the form of money or cash. Thus liquidity means cash.
The liquidity can be studied with reference to the rate of interest. If in any society people prefer to keep their income in the form of liquidity then we have to pay higher rate of interest. People will be prepared to part with liquidity when they are paid higher rate of interest. When the rate of interest is low they will prefer to keep if in liquid form.
Thus, interest is a reward for parting with liquidity. Hence higher the liquidity preference higher will be the rate of interest and lower the liquidity preference lower will be the rate of interest.
Motives for Liquidity Preference:
What are the motives for liquidity preference depend on several things in any society.
The demand for liquidity depends upon these motives as are discussed below:
(1) Transaction Motive:
All the persons are required to keep a part of their income in cash in order to purchase goods and services of daily use. The demand for such motive is called transaction demand for liquidity for meeting their day-to-day needs of their life.
The demand for liquidity for transaction motive depends upon the level of income and employment, time lag in income and expenditure in a country. The changes in incomes of the people bring changes in the demand for liquidity for transaction motive. The demand for liquidity for this motive is income elastic [L1=f(y)] because it is the level of income by which the demand is determined.
(2) Precautionary Motive:
Another demand for money is from people to meet unforeseen events of life. Each person or businessman has to keep a part of his income in liquid form to meet the emergency requirements like sickness, accident, unemployment and other emergency requirements. The demand for liquidity for this motive is also determined by nature, psychology and level of income of an individual.
The demand will be high when the persons are foresighted. The demand for money for meeting this motive is also income elastic [L1=f(y)]. Poor people keep less while rich people keep high amount of money for meeting this motive.
(3) Speculative Motive:
Professor J.M. Keynes has emphasised this motive for the determination of rate of interest. According to Keynes, “Speculative motive is for securing profit from knowing better than the market what the future will bring forth.” People keep a part of their income in liquid form or cash in order to earn the profit by investing it in shares, debentures, bonds, government securities and making loans and advances to individuals, businessmen and traders.
People will keep high amount in cash when the future prices of shares, debentures and bonds are expected to fall and less amount of money when their prices are going to rise in future. Thus, the demand for money for speculative motive is income inelastic and it is interest elastic [L2=f(r)].
Thus, the total demand for money or liquidity is denoted by these motives. The first two motives are income elastic which is denoted by the following formula-
L1=f(y)
While the demand for speculative motive is interest elastic and it can be denoted by the following formula-
L2 = f (r)
The total demand for liquidity preference is equal to-
LP = L1 + L2
The demand for liquidity preference and the rate of interest can be studied with Diagram 7.
Rate of interest is shown on OY-axis and the demand for liquidity or money is shown on OX-axis. LP is the demand for liquidity preference. There is inverse relationship between the rate of interest and demand for liquidity preference. Higher the rate of interest higher will be the demand for liquidity preference and lower the rate of interest higher will be the demand for liquidity preference. When the rate of interest is OR the demand of liquidity is OQm.
When the rate of interest increases from OR to OR2 the demand for liquidity is reduced from OQm to OQm2 and with the fall in the rate of interest to OR1 the demand for liquidity increases to OQm1. There is liquidity trap when the rate of interest is so low that people would not like to make loans and advances because it is not profitable.
Supply of Liquidity or Money:
Supply of money consists of coins, paper currency and bank credit. It increases the supply of liquidity in an economy during a given period. The supply of money remains constant because it depends upon the monetary authority of a country. Thus, the quantity of money issued by the central bank and its credit policy are the determinants of money supply in the country. It is assumed constant.
The supply of money and the rate of interest relationship can be studied by the following diagram:
Thus, the rate of interest during a given period has no effect on the supply of money or liquidity.
Determination of the Rate of Interest:
According to Keynesian theory of interest, the rate of interest will be determined at the point where the demand for liquidity (LP) curve cuts the supply of money (SM) curve as shown in the diagram-
In the diagram rate of interest is shown on OY-axis and quantity of liquidity (demand for and supply of money of liquidity) on the OX-axis. OR is the rate of interest and OM is the quantity of liquidity, E is the point of equilibrium where the LP cuts the SM curve. LP shows the demand for liquidity and SM shows the supply of money or liquidity.
Now we will see the effects on the rate of interest due to change in the demand for liquidity (LP) keeping supply of liquidity (SM) constant and change in supply of liquidity keeping the demand for liquidity constant.
When the demand for liquidity changes keeping the supply of liquidity constant the change in LP and the rate of interest will move in the same direction as given in Diagram 10.
The initial rate of interest is determined at point E where the LP curve cuts the SM curve. OR is the rate of interest and OM is the quantity of liquidity. When the demand for liquidity increases the LP curve will shift to the right side of the original LP curve and the point of equilibrium will be at E1 where OR1 is the rate of interest keeping supply of liquidity (SM) constant.
When the demand for liquidity decreases the LP curve will move downward to the left of the original LP curve and the point of equilibrium will be at E2 where the rate of interest is OR2 and the quantity of liquidity is OM.
Thus there is direct and positive relation between the liquidity preference (demand for liquidity) and the rate of interest. With the increase in the LP the rate of interest will increase and with the decrease in LP the rate of interest will decrease.
When the demand for liquidity (LP) remains constant and the supply of liquidity (SM) changes the relationship between supply of liquidity and rate of interest will be inverse. With the increase in the supply of liquidity (SM) the rate of interest will fall and with the decrease in supply of liquidity the rate of interest will increase as shown in the following diagram-
The original equilibrium is E where LP curve cuts the SM curve and OR is the rate of interest and OM is the quantity of liquidity. When the supply of liquidity increases the SM curve shifts to right and the point of equilibrium is at E1 where LP cuts the S1M1 curve, OR1 is the rate of interest and the quantity of liquidity is OM1.
Contrary to it when the supply of liquidity decreases the SM curve shifts towards the left side of the original supply curve (SM) and the point of equilibrium is attained at point E2 where the LP curve cuts the S2M2 and the rate of interest is determined OR2 and the quantity of liquidity is OM2. Thus, there is inverse relation between supply of liquidity and the rate of interest. The rate of interest will increase with the increase in demand for liquidity keeping the supply of liquidity constant.
Criticism of the Theory:
The liquidity preference theory of interest has been criticised on the following grounds:
(1) The Theory Ignores Real Factors:
It ignores real factors while determining the rate of interest. The theory is purely a monetary theory. Sacrifice, waiting and productivity are the real factors which are also important for the determination of the rate of interest.
(2) No Liquidity without Saving:
The theory emphasises on the liquidity and rate of interest is considered as a reward for parting with liquidity. Liquidity cannot be possible without saving.
(3) One Sided Theory:
The theory assumes that the supply of money or liquidity remains constant while the demand for liquidity changes and the rate of interest is determined where LP curve cuts the SM curve. It has emphasised on the demand for liquidity while the supply of liquidity is kept constant which is one sided determination of the rate of interest.
(4) The Theory is Related with Short Period:
It fails to determine the rate of interest during the long period. During long period trade cycles lead to fluctuations and in such a situation theory fails to determine the rate of interest.
(5) The Theory Fails to Explain the Causes of Different Rates of Interest:
It does not explain the differentials in interest rate keeping the uniformity in the liquidity preference of the people.
(6) Contrary to Facts:
The liquidity preference theory of interest is contrary to the general experience and facts. The rate of interest should be the highest during the lowest level of depression because people have demand for liquidity but it is not so which has not been explained by the theory. Rates of interest are at the highest when the prosperity is at its highest level.
(7) Indeterminate:
The liquidity preference theory of interest is indeterminate. As pointed out by Professor Keynes that the rate of interest is determined by the liquidity preference and the quantity of money. Until and unless we know the level of income the demand and supply of money cannot be known and the rate of interest remains indeterminate. Prof. Keynes has failed in explaining this point.
(8) Money as Store of Wealth is not Correct:
The theory assumes that liquidity or money plays a role of store of wealth or speculative purpose but in practice we see that money is as productive as other assets are.
(9) Limited Scope:
The liquidity preference theory is a monetary theory for the determination of rate of interest. Monetary factors have been taken into consideration. It means the theory is applicable in monetary economies only and it cannot be applied to non-monetary economies.
4. Modern Theory of Interest:
Professor Hanson and Professor Lerner have propounded the modern theory of interest. The theory has taken into consideration some of the elements of classical theory of interest and liquidity preference theory of interest. The theory has taken four determinants of the rate of interest, namely, saving function (S), the investment function (I), the liquidity preference function (L) and the supply of money function (M).
The modern theory has evolved two curves, namely, the IS curve consisting of investment and saving and the LM curve consisting of liquidity preference and the quantity of money. The rate of interest is determined at the point where the IS curve intersects the LM curve. IS curve represents the equilibrium in real sector and LM curve represents the equilibrium in monetary sector.
At the equilibrium rate of interest real sector and monetary sector are at equilibrium. At this rate of interest at the given level of income total savings are equal to total investment (S=I) and the total demand for and total supply of money are also equal.
Derivation of IS Curve:
The IS curve can be depicted by the diagram where different levels of income and rates of interest are studied and total real savings are equal to total real investment. The derivation of IS curve can be studied from Diagram 12.
The part of the diagram shows the relationship between the rate of interest and the saving and investment. SS, S1S1 and S2S2 are different levels of savings at different levels of income and the points of equilibrium between saving and investment are shown by E, E1 and E2 whereas the rate of interest are OR, OR1 and OR2. It is the investment curve where the relation between rate of interest and investment is inverse. Higher the rate of interest lower will be the investment and lower the rate of interest higher will be the investment.
When the rates of interest at different levels of income having equilibrium between saving and investment are expressed by a curve knows as IS curve as shown in the part (B) of the Diagram 12. IS curve show the relationship between different levels of income and rates of interest in which the related saving and investment are in equilibrium.
The slope of IS curve is negative showing the inverse relationship between the level of income and the rate of interest. At the higher level of income saving will be high and rate of interest will be low while at the lower level of income the saving will be low and the rate of interest will be high.
Derivation of LM Curve:
LM curve shows the various combinations of different levels of income (y) and rates of interest (r) wherein there is equilibrium between the demands for money and supply of money. It can be seen from Diagram 13.
The part (A) of the diagram shows that there is positive relationship with the liquidity preference and the rate of interest keeping the supply of money (SM) constant. LP increases with the increase in the level of income and thereby the rate of interest increases.
In part (B) of the diagram, the LM curve has been shown wherein there is positive relationship between the rate of interest and the levels of income. Its each point shows equilibrium between the demand for money and supply of money. When the supply of money is given then the increased income will increase the liquidity preference and the rate of interest will increase.
Determination of Rate of Interest
The rate of interest is determined at the point where the IS curve and LM curve intersects each other.
It is shown in the following diagram:
Rate of interest is shown on OY-axis and the level of income on OX-axis. The rate of interest is determined at point E where the IS curve cuts the LM curve. The rate of interest is OR and the level of income is OY1. It shows the equilibrium between saving and investment (SI) on the one hand and equilibrium between liquidity and supply of money (LM) on the other.
According to the expectations theory, the expectations regarding future interest rates determine the present term structure of interest rates. The theory explains the different shapes of the yield curves in terms of substitution that investors are likely to make as a result of the changes in their expectations concerning future interest rates.
Consider an investor who wishes to invest Rs. 100 for two years.
He has two options:
(a) He can invest for the whole two years, or
(b) He can invest for one year and then reinvest both principal and interest for one more year at the rate of interest which is expected to prevail after one year.
Naturally, the investor’s expectation about next year’s rate of interest is very important in deciding between the two options.
For example, if the current rate of interest on two-year loans is 9%, the investment of Rs. 100 now will give a return of Rs. 118.81 after two years, i.e.,
Option I: Rs 100 (1 + 0.09)2 = Rs 118.81 after two years.
If the current rate of interest on one-year loans is 8% and the expected rate of interest on one-year loans one year from now is 10.01% it will be possible for the investor to invest Rs. 100 now at 8% and get Rs. 108 after one year and reinvest the same Rs. 108 at 10.01 % for another year, yielding Rs.118.81.
Option II: Rs. 100 (1 + 0.08) = Rs. 108 after one year.
Rs. 108 (1 + 0.1001) = Rs. 118.81 after two years.
It is clear from this example that if the investors expect that the rate of interest for one-year loans one year front now will be 10.01%, they will find no difference between investing for two years at 9% (i.e. option I) and investing for one year at 8% and second year at 10.01 % (option II) because both the options will have the same return (i.e., Rs 118.81 after two years). So long as the expected rate of 10.01% for one-year loans in one year’s time persists, there will be no change in the current term structure of interest rates (i.e., 8% and 9% for one and two-year loans respectively).
The equilibrium terms structure of 8% and 9% rates of interest for short-term and long-term loans respectively (in this example, for one and two-year loans respectively) is shown in Figure 13A an B. 8% rate of interest is represented by the intersection of demand and supply curves for one-year loans (DD and SS curves respectively) in Figure 13 A.
Similarly, 9% rate of interest is represented by the intersection of the demand and supply curves for two-year loans (DD and SS curves respectively) in Figure 13B. In this situation, the yield curve is an upward sloping curve (like the one shown in Figure 14A) indicating 9% interest rate for two-year loans and 8% interest rate for one-year loans with the expectation that after one year the rate of interest on one-year loans will be 10.01 %.
Change in Expected Interest Rates:
If there is a change in the expected interest rates, the equilibrium in the financial market will be disturbed; the investors will find a difference between the two options (i.e., investing for two year once and investing for one year twice); they will no longer be indifferent because return from the two options will differ; the demand and supply curves will shift; and the term structure of interest rates will change.
Suppose, for example, the expected rate of interest on one-year loans one year from now falls from 10.01 % to 7%. In this case the sequential investment in two one-year loans (option II) will yield only Rs. 115.56. This is less than the return (i.e., Rs. 118.81) which the investor would have received had he invested his funds for the entire two years at 9% interest rate (i, e., had he chosen Option I).
Thus, there arises a disequilibrium between the two options:
Option I: Rs. 100 (1+0.09)2 = Rs. 118.81 after two years.
Option II: Rs. 100 (1+0.08) = Rs. 108 after one year.
Rs. 108 (1 + 0.07) = Rs. 115.56 after two years. In this disequilibrium situation, soon the adjustment process (the arbitrage procedure) involving buying one maturity and selling another will start which will ultimately bring about a new equilibrium in the market The reduction in the return from Option II (i. e., from investing in one-year loans in each of two years) will cause some investors to shift to Option I (i.e., to lending in two-year loans).
This will shift the supply curves in Figure 13 A and B from SS to S’S’. Similarly, the borrowers expect to repay less by sequential borrowing for two one-year periods (Option II) rather than borrowing for the entire two-year period at one time (Option I); thus they shift from Option I to Option II. This will shift the demand curves in Figure 13 A and B from DD to D’D’ As a result of the shifts in the demand and supply curves, a new equilibrium term structure emerges with the rate of interest on one-year loans fixed at 8.3% and the rate on two-year loans fixed at 7.65 %.
The investors again find no difference between investing for two years at 7.65% and investing for one years at 8.3% and the second year at 7% because the total return after two years in both the options will be the same (i.e., Rs. 115.88)-
Option I: Rs. 100 (1 + 0.0765)2 = Rs. 115.88 after two years.
Option II: Rs. 100 (1 + 0.083) = Rs. 108.30 after one year.
Rs. 108.30 (1 + 0.07) = Rs. 115.88 after two years.
Thus, a change in the expectations leads to a change in the term structure of interest rates. When the expectation for one-year loans one year from now falls from 10.01 % to 7%, the current supplies and demands for one and two- years loans shift until the rate on one-year loans rises from 8% to 8.3% and the rate on two-year loans falls from 9% to 7.65%. The yield curve in this case of reduction in the expected interest rate (from 10.01% to 7%) will be a downward sloping curve (like the one shown in Figure 14B) indicating higher interest rate (8.03) for one-year loans and lower interest rate (7.65%) for two-year loans.
The expectations theory can be alternatively explained in terms of bonds. The bond prices vary inversely with the rate of interest. If the market interest rates are expected to rise (i.e., the bond prices are expected to fall), the investors will tend to sell their long-term bonds to avoid anticipated capital losses as market rates of interest rise (or as the bond prices fall).
As a result, the demand for long-term bonds will fall and the demand for short-term bonds will rise; the price of long-term bonds will fall and the price of short-term bonds will rise; the-rate of interest (yield) on long-term bonds will rise and the rate of interest (yield) on the short-term bonds will fall. This is the case of an upward sloping yield curve (as shown in Figure 14 A).
On the contrary, if there are expectations of falling market rates of interest in future (i.e., of rising bond prices), the investors who possess short-term bonds will see the possibility of getting a capital gain if they buy long-term bonds that have the same yield as short-term bonds.
As a result, the demand for long-term bonds will rise and the demand for short-term bonds will fall; the price of long-term bonds will rise and the price of short- term bonds will fall; the rate of interest (yield) on long-term bonds will fall and the rate of interest (yield) on short- term bonds will rise. This is the case of a downward sloping yield curve (as shown in Figure 14B).
Conclusions of Expectations Theory:
Various conclusions of the expectations theory of term structure are given below:
(i) Changes in the expectations concerning the future market rates of interest are the major determinant of the changes in the term structure of interest rates.
(ii) The investors-follow the arbitrage process, i.e., they switch between long and short-term loans in accordance with the changes in the expectations until a long-term loan provides the same yield as the series of short-term loans for the same period of time. In other words, the money and capital markets adjust quickly to changes in expectations so that these markets can be reasonably assumed to be always in equilibrium.
(iii) If the market rate of interest is expected to rise in future, the borrowers shift from shorter to longer maturity loans and the lenders shift from longer to shorter maturity loans. As a consequence, the short- term rate of interest falls and the long-term rate of interest rise. Or, in other words, the yield on short- term loans falls and the yield on long term loans rises. This gives an upward sloping yield curve as shown in Figure 14A.
(iv) If the market rate of interest is expected to fall in future, the borrowers shift from longer to shorter maturity loans and the investors shift from shorter to longer maturity loans. As a consequence, the short-term rate of interest increases and the long-term rate of interest decrease. Or in other words, the yield on short-term loans rises and the yield on long-term loans falls. This gives a downward sloping yield curve as shown in Figure 14B.
(v) If the market rates of interest are expected to remain constant throughout the future, the rates on longer maturity loans will be the same as those on shorter maturity loans. The result will be a flat yield curve as shown in Figure 14C.
(vi) If the market rates of interest are expected first to rise in the immediate future and fall later on, this will provide a hump-backed yield curve as shown in Figure 14D.
Limitations:
The expectations theory of term structure suffers from the following limitations:
(i) The theory assumes that expectations held by the market actually materialise so that the expected rates do become reality. Critics point out that the expectations need not come out to be true. Therefore the investors many times revise their expectations in the light of their experience through error- learning process.
(ii) The theory implicitly assumes that the authorities are not capable of influencing the term structure by public debt management and changes in the supply of credit. In reality, the authorities, by changing the total amount of public debt and by changing its maturity composition, are able to influence the term structure of interest rates.
(iii) The theory also wrongly assumes that the investors are able to make precise and correct expectations regarding the future behaviour of short-term rates of interest. This is demanding too much information from the investors.
(iv) It is a theory in which short-period interest rates are used as causes and long-period rates as the effect. It is possible to formulate a theory in which long-period rates are used as the cause to explain the determination of short-period rates. What is thus needed is to explain why longer maturity rates should be dependent upon shorter maturity rates and not the other way round.
In spite of these limitations, the expectations theory is not only widely accepted as a better theory of term structure of interest rates but also has been found empirically valid. The results of various studies have tended to give strong support to the expectations theory, particularly to its modified version which accepts the existence of a liquidity premium on long-term bonds.
6. Liquidity Premium Theory:
The liquidity premium theory accepts the expectations approach that expectations of changes in the interest rates affect the term structure of interest rates. But, it maintains that the expectations are not the only factor influencing the term structure; liquidity factor also explains part of this structure.
If the expectations theory is correct, then there are equal chances of having yield curves sloping upward to the right or sloping downward to the right. But, in reality, the yield curves tend to slope upward to the right on more occasions than they slope downward. To get an explanation of this fact, the liquidity premium theory of the term structure should be added to the expectations theory.
According to the liquidity premium theory, the interest rate on long-term maturities is higher than that on short-term maturities (or the yield curve slopes upward to the right) because a liquidity premium must be added to the yields of long-term maturities. The theory is based on the fact that interest-rate risk is more on the longer maturity securities.
As a result of change in the rate of interest, there is a small chance of making a capital loss (as a result of a fall in the interest rate) and a small chance of making a capital gain (as a result of a rise in the interest rate). But, with the increase in the length of maturity, the risk of capital loss (or gain) also increases. Investors being risk averters prefer securities with shorter maturity. Therefore, premium must be added to the return of longer-term maturities to attract the risk-averse buyers. In this sense, the liquidity premium factor always causes longer-maturity rates to be higher than the shorter-maturity.
In view of the greater interest-rate risk on long-term securities some investors may attempt to forgo some expected return in order to hold short-term securities. Even though the investor takes decisions primarily on the basis of his expectations about the future course of interest rates, he is also aware that the expectations may not come true.
For example, a cautious investor will certainly prefer a return of 6.25% on short-term securities to a return of 6.50% on long-term securities that will be earned only if his expectations are realised. If this is true, then the short-term interest rates would always be lower than it might have been if the structure of rates of interest had been determined by expectations alone.
Limitations:
Though the liquidity premium theory is an improvement upon the expectations theory and the latter should be augmented by the former, still it is criticised on the following grounds:
(i) The theory takes for granted the role of liquidity premiums. But, in reality, different investors do not have the same degree of risk aversion. This makes it difficult to determine liquidity premium.
(ii) Again, since change in the interest-rate risk is not proportionate to the change in maturity, it is not possible to determine in advance the liquidity premium for maturity for a given level of interest rate.
(iii) The theory also does not explain the formulation of expectations and changes therein. The problem of explaining the changes in the expectations becomes all the more significant when the investors find their expectations not materialising. The theory does not tell how the expectations are modified in such a situation.
7. Market Segmentation Theory:
The market segmentation theory has been developed as an alternative to the expectations theory. It denies the basic assumption of the expectations theory that a great deal of substitution can occur between securities with different maturities. On the contrary, the market segmentation theory is based on the fact that the security markets are dominated by large financial institutions that cannot easily make the kind of substitution that the expectations theory needs.
The market segmentation theory maintains that interest rates are determined in several separated or segmented markets. Buyers and sellers of credit instruments specialise in credit instruments of different maturities and are not considered good substitutes. For example, commercial banks have primarily short-term liabilities and therefore the credit instruments they purchase are short-term. Life insurance companies, on the other hand, have long-term liabilities and tend to purchase long-term credit instruments.
According to the market segmented theory, since the credit instruments of different maturities are traded in segmented markets, the yield curve results from the interplay of several supply and demand functions and can take any shape. For example, an increase in the supply of long-term securities will tend to reduce their price and hence raise their yield (rate of interest), without affecting the rate of interest on short-term securities. This will give a yield curve, sloping upward to the right.
Similarly, an increase in the supply of short-term securities will tend to reduce their price and thus the rate of interest on these short-term securities will rise, without affecting the interest rate on long-term securities. This results in a yield curve sloping downward to the right.
The market segmentation theory has important implications for monetary policy in the economies where markets are truly segmented. Monetary authorities can operate in either long-term or short- term credit markets without having any significant impact on other credit markets.
For example, monetary policy can be operated in the short-term markets with an objective of raising short-term interest rates to encourage foreign money inflows or to reduce money outflows or to lessen a balance of payment problem. Again monetary policy may operate in long- term markets to lower the long-term interest rates to encourage domestic capital expansion.
There is no doubt that in practice, segmentation of financial markets does exist and also influence the term structure of the interest rates. But, it is not clear that the segmentation is as clear as the theory requires. In reality, the markets in which investors and institutions function largely overlap. For example, the commercial banks may not consider purchasing a 30-year bond but may be willing to consider any maturity upto ten years.
Saving banks may operate in 5 to 10-years maturity range. The life insurance company may not consider anything under ten years, but may be interested in any longer maturities. In this way, the degree of overlap may be large enough so that the market as a whole may produce results similar to those expected under the expectations theory.
1. The Abstinence or Waiting Theory of Interest:
This theory of interest was advocated by Senior. Interest is a reward for abstinence. When an individual saves money from his/her income and lends it to somebody else, he/she sacrifices. Sacrifice in the sense that he/she abstains from consuming the whole of his/her income which he/ she could have simply spent. As abstaining from consumption is disagreeable and painful, so the lender must be rewarded for this.
Thus, according to Senior, interest is the reward for abstinence from the use. This theory is discarded on the ground that saving does not necessarily entail pain or sacrifice. A rich millionaire may save and lend a major part of his income without undergoing any hardship or suffering.
Alfred Marshall, realized this flaw in Senior’s definition and thereby substituted the term waiting for abstinence. Interest for Marshall is the reward for waiting. When a man saves a part of his income, he simply postpones his current consumption to some future date.
During a period when money is loaned, he himself might require money. But he cannot get it back from the borrower as the period of loan is fixed. He has to wait for the return of loan. In order to encourage the spirit of waiting amongst the lenders, some enticement is necessary and this incentive according to Marshall, is interest.
2. Bohm-Bawerk’s View of Interest:
Among the early theories of interest, the Bohm-Bawerk’s theory of interest also recognized as Austrian theory of interest is prominent. An Austrian economist, Bohm-Bawerk opined that interest is paid for lending present income against the promise of future income. People prefer present consumption of goods to their future consumption which results in the rise of interest.
People prefer present enjoyment to future enjoyment. Interest is the discount which must be incurred in order to induce people to lend money and therefore postpone their present satisfactions to a future date.
Bohm-Bawerk advanced three reasons for the emergence of the rate of interest. The first reason was that the demands for goods in the present is relatively greater than the demand for the same goods in the future. People feel the present wants more keenly than the future wants.
The conditions of wants and availability of the present wants are different from that of the future wants. Hence, demand for goods is greater in the present than in the future. The second reason forwarded by Bohm-Bawerk is that people tend to underrate future wants.
People basically undervalue future wants because (a) they lack the capacity of imagining the future (b) the people have inadequate will power and therefore find it hard to control the temptation of satisfying the present wants. (c) Uncertainty of future profoundly influences the people. They are not sure whether they may live long enough to enjoy the future wants.
The third reason which Bohm- Bawerk provided was about the technical superiority of the present goods in comparison to the future goods. Present goods invested now in the round -about method of production would produce a large physical output in the future. Due to higher productivity of Capital people prefer to have present goods which can be used as capital so that they have more goods in the future.
3. Fisher’s Theory:
Time Preference is the Basic Source of Interest:
Irving Fisher is rightly considered as one of the pioneers of neo-classical economics. In The Theory of Interest (1930) Fisher developed what is still thought as the modern theory of inter temporal choice. The well-known Fisher Figure is still a vital element of any course on microeconomics, macroeconomics and finance. Fisher starts his theory of interest with the basic determinants of time preference or impatience (he has used the terms synonymously).
He divides his discussion into two parts-the influence of economic factors (i.e., income) and what he calls’ personal’ factors. Fisher opined that an individual’s impatience depends on four characteristics of his income stream- the size, its time shape, its composition and its risk.
Rate of interest arises because people prefer present satisfactions to future satisfactions. They are therefore impatient to spend their incomes in the present. According to Fisher, interest is a compensation for the time preference of the individual. The higher the impatience to spend money in the present, that is, the higher the preference of individuals for present enjoyment of to future enjoyment of them, the higher have to be the rate of interest to induce them to lend money.
The level of impatience to spend income in the present depends upon the size of the income, the allocation of income over time, the level of certainty regarding enjoyment in the future and the temperament and character of the individual. The people whose incomes are high are likely to have their present wants more fully satisfied. Therefore, these rich people will discount the future at a relatively lower rate of interest (i.e., their time preference will be less) and will be required to be paid a relatively lower rate of interest.
Fisher based his explanation of the rate of interest on his concept of income. According to him, interest is the link between anticipated future income values and the present capital values based on them.
Fisher also regarded productivity of capital which he first called, ‘rate of return over sacrifice’. And later rate of return over cost, as a determinant of interest. According to him, several different uses of capital which may yield different income streams are open to the owner of capital. He has to decide about the investment of his capital. The greater the expected income stream from use of capital, the greater will be the rate of interest.
Comments are closed.