Interest has been defined as the price for the use of capital. It is net interest which a part of gross interest. When interest includes the payment for risks, inconveniences, management and money capital, it is called gross interest.
According to the loanable Fund Theory of Interest (Neo-classical Theory) rate of interest depends on the demand for and supply of the loanable fund. Supply of loanable funds comes from savings, bank, credit, dishoarding and disinvestment.
Demand for loanable funds comes from households, firms and government for consumption, investment and hoarding. The rate of interest will be determined where demand for loanable funds and supply of loanable funds are equal. But the theory is subject to criticisms.
According to Keynes’ Liquidity preference theory of Interest, liquidity preference means desire to hold cash or demand for money. This is based on transactions motive, precautionary motive and speculative motive.
The first two motives are income elastic whereas speculative motive is interest elastic. The demand for cash for the first two motives is limited and is not affected much by the rate interest.
The rate of interest according to Keynes is determined by the equilibrium of the demand for money and supply of money. The supply of money is made by the Central Bank of the country. At any given time, the supply of money is perfectly inelastic or fixed as the issue of currency by the Central Bank cannot be increased arbitrarily. Hence, it is not affected by the rate of interest.
Rate of interest is determined by the intersection of the liquidity preference curve (or demand curve) and supply curve of money. The theory is subject to criticisms. The most important criticism of the theory is that it is indeterminate.