In this article we will discuss about the modern theory of interest with its criticisms.
An adequate theory to be determinate must take into consideration both the real and monetary factors that influence the interest rate.
Hicks has utilized the Keynesian tools in a method of presentation which shows that productivity, thrift, liquidity preference and money supply are all necessary elements in a comprehensive and determinate interest theory.
According to Hansen, “An equilibrium condition is reached when the desired volume of cash balances equals the quantity of money, when the marginal efficiency of capital is equal to the rate of interest and finally, when the volume of investment is equal to the normal or desired volume of saving. And these factors are inter-related.” Thus in the modern theory of interest rate, saving, investment, liquidity preference and the quantity of money are integrated at various levels of income for a synthesis of the loanable funds theory with the liquidity preference theory.
The four variables of the two formulations have been combined to construct two new curves, the IS curve representing flow variable of the loanable funds formulation (or the real factors of the classical theory) and the LM curve representing the stock variables of liquidity preference formulation. The equilibrium between IS and LM curves provides a determinate solution.
The IS Curve:
The IS curve has been derived from the loanable funds formulation. It is a curve which explains the relationship between a family of saving schedules and investment schedules. In other wards, this curve shows the equality of saving and investment at various combinations of the levels of income and the rates of interest. In Figure 8 (A), the saving curve S in relation to income is drawn in a fixed position, since the influence of interest on saving is assumed to be negligible.
The saving curve shows that saving increases as income increases, viz., saving is an increasing function of income. Investment, on the other hand, depends on the rate of interest and the level of income. Given a level of interest rates, the level of investment rises with the level of income. At a 5 per cent rate of interest, the investment curve is I2. If the rate of interest is reduced to 4 per cent, the investment curve will shift upward to I3.
The rate of investment will have to be raised to reduce the marginal efficiency of capital to equality with the lower rate of interest. Thus the investment curve I3 shows more investment at every level of income. Similarly when the interest rate is raised to 6 per cent, the investment curve will shift downward to l1The reduction in the rate of investment is essential to raise the marginal efficiency of capital to equality with the higher interest rate. In Figure 8 (B), just below Figure 8 (A), we derive the IS curve by marking the level of income at various interest rates. Each point on this IS curve represents a level of income at which saving equals investment at various interest rates.
The rate of interest is represented on the vertical axis and the level of income on the horizontal axis. If the rate of interest is 6 per cent, the S curve intersects the 7, curve at E which determines OY; income. From this income level which equals Rs100crores we draw a dashed line downward to intersect the extended line from 6 per cent at point A. At interest rate 5 per cent, the S curve intersects the I2 curve at E2 so as to determine OY2 income (Rs200 crores).
In the lower Figure 8 (B), the point B corresponds to 5 per cent interest rate and Rs200crores income level. Similarly, the point C corresponds to the equilibrium of S and I3 at 4 per cent interest rate. By connecting these points A, B and C with a line, we get the IS curve. The IS curve slopes downward from left to right because as the interest rate falls, investment increases and so does income.
The LM Curve:
The LM curve shows all combinations of interest rates and levels of income at which the demand for and supply of money are equal. The LM curve is derived from the Keynesian formulation of liquidity preference schedules and the schedule of supply of money.
A family of liquidity preference curves LtY1, L2Y2 and L3Y3 is drawn at income levels of Rs100crores, Rs200crores and Rs300crores respectively in Figure 9 (A). These curves together with the perfectly inelastic money supply curve MQ give us the LM curve.
The LM curve consists of a series of points, each point representing an interest-income level at which the demand for money (L) equals the supply of money (M). If the income Level is Y (Rs. 100 crores), the demand for money (L1Y1) equals the money supply (QM) at interest rate OR r At the Y2 (Rs. 200 crores.) income level, the L2Y2 and the QM curves equal at OR^ interest rate. Similarly at the Y3 (Rs. 300 crores) income level, the L3Y3 and QM curves equal at OR3 interest rate.
The supply of money, the liquidity preference, the level of income and the rate of interest provide data for the LM curve shown in Figure 9 (B). Suppose the level of income is Yt (Rs100crores), as marked out on the income axis in Figure 9 (B).
The income of Rs.100crores generates a demand for money represented by the liquidity preference curve L1Y1. From the point Â£, where the L1Y1 curve intersects the MQ curve, extends a dashed line horizontally to the right so as to meet the line drawn upward from Y1 at K in Figure 9 (B). Points S and T can also be determined in a similar manner. By connecting these points K, S and T with a line, we get the LM curve. This curve relates different income levels to various interest rates, but it does not show what the rate of interest will be.
The LM curve slopes upward from left to right because given the quantity of money, an increasing preference for liquidity manifests itself in a higher rate of interest. It also becomes gradually perfectly inelastic shown as the vertical portion from T above on the LM curve in Panel (B) of Figure 9. This is because at higher income levels the demand for transaction and precautionary motives increases so that little is left to satisfy the demand for speculative motive out of a given supply of money.
We may also note that at the extreme left the LM curve is perfectly elastic in relation to the rate of interest. This is shown as the horizontal portion of the LM curve which starts from the vertical axis in Panel (B) of Figure 9. With the decline in the level of income, the demand for transactions and precautionary motives also declines.
Thus a larger amount is available in the form of idle balances but it does not lead to the lowering of the interest rate because we have reached the limit to which the rate of interest will fall. This lower limit to which the rate of interest will fall is the Keynesian liquidity trap already explained above in Keynes’s theory of interest.
Determination of the Rate of Interest:
The IS and LM curves relate to income levels and interest rates. Taken by themselves they cannot tell us either about the level of income or the rate of interest. It is only their intersection that determines the rate of interest. This is illustrated in Figure 10 where the LM and IS curves intersect at point E and OR rate of interest is determined corresponding to the income level OY.
The income level and the interest rate lead to simultaneous equilibrium in the real (saving-investment) market and the money (demand and supply of money) market. This general equilibrium position persists at a point of time. If there is any deviation from this equilibrium position, certain forces will act and react in such a. manner that the equilibrium will be restored. At the income level OYt the rate of interest in the real market is Y1B and it is Y A in the money market. When the former rate is higher than the latter rate (Y1B> Y1A), the businessmen will borrow at a lower rate from the money market and invest the borrowed funds at a higher rate in the capital market.
This will tend to raise the level of income to OY via the investment multiplier and the equilibrium level of OR interest rate will be reached. On the other hand, at the income level OY2 the rate of interest in the real market is less than the interest rate in the money market (Y2C < Y2D). In this situation, the businessmen will try to discharge debts in the money market rather than invest in the capital market. As a result, investment will fall and reduce income by the multiplier to OY and the equilibrium rate of interest OR will be established,
Shifts or changes in the IS curve or the LM curve or in both change the equilibrium position and the rate of interest is determined accordingly. These are illustrated in Figure 11. Let IS and LM be the original curves. They intersect at E where OR interest rate is determined at OY income level. If the investment demand schedule shifts upward, or the saving schedule shifts downward, the curve IS would shift to the right as IS1 curve.
Given the LM curve, equilibrium will take place at E1. The rate of interest would be OR1 and the income level OY1. If the quantity of money is increased or the liquidity preference curve is lowered, the LM curve would shift to the rights as LM1 .It intersects IS1curve at point E2.
The new equilibrium rate of interest is OR and the income level is OY2 Thus with a given LM curve, when the IS curve shifts to the right income increases and along with it the rate of interest also rises. Given the IS curve, when the LM curve shifts to the right, income increases but the rate of interest falls.
The Hicks-Hansen analysis is thus an integrated and determinate theory of interest in which the two determinates, the IS and LM curves, based on productivity, thrift, liquidity preference and the supply of money, all play their parts in the determination of the rate of interest.
Criticisms of the Modern Theory of Interest:
Despite its merits, the Hicks.-Hansen theory of interest rate is not free from certain weaknesses.
1. Static Theory. It is a static theory that explains the short-run behaviour of the economy. Thus it fails to explain how the economy behaves in the long run.
2. Interest Rate not Flexible. The theory is based on the assumption that the interest rate is flexible and varies with changes in LM or/and IS curves. But it may not always happen if the interest rate happens to be rigid because the adjustment mechanism will not take place.
3. Investment not Interest Elastic. The theory assumes that investment is interest elastic. But if investment is interest inelastic, as is generally the case in practice, then the Hicks-Hansen theory does not hold good.
4. Highly Artificial. According to Don Patinkin, the Hicks-Hansen theory is highly artificial and oversimplified because it divides the economy into real and monetary sectors. In reality, the real and monetary sectors of the economy are so interrelated and interdependent that they act and react on each other.
5. Closed Model. According to Prof. Rowan, the Hicks-Hansen theory is a closed model which does not take into consideration the effect of international trade. This restricts its usefulness for the study of policy.
6. Price Level Exogenous Variable. The price level is treated as an exogenous variable in this model. This is unrealistic because price changes play an important role in the determination of income and interest rates in an economy. Despite these weaknesses, this theory does not undermine the utility of the IS-LM technique in explaining the determination of interest rate in an economy.