What is the Concept of Interest?

As is commonly understood, interest is the payment made by the borrower to the lender of a money loan. It is usually expressed as an annual rate in terms of money and is calculated on the principal of the loan.

We may define interest as the price paid for the use of others’ capital funds for a certain period of time. In the real economic sense, however, interest implies the return to capital as a factor of production.

But, for all practical purposes, interest may be conceived of as a price of a money loan, i.e., liquid capital, which may be borrowed either for production or even for consumption purposes.

Interest is the price paid for the productive services rendered by capital. Interest is a compensation demanded by the lender of money funds for parting with liquidity.

The following are the major functions of interest in modern economic systems:

1. It encourages consumers to save more.

2. It provides capital for constructive productive services, and thereby helps the economic growth.

3. It helps allocation of savings in different productive channels.

4. It regulates the flow of funds.

Gross and Net Interest:

The actual amount paid by the borrower to the capitalist as the price of capital fund borrowed is called gross interest, while the payment made exclusively for the use of capital is regarded as net or pure interest.

Gross interest includes, besides net interest, the following elements:

1. Compensation for risk:

Giving a money loan to somebody always involves a risk that the borrower may not repay it. To cover this risk, the lender charges more, in addition to the net interest. Thus, when loans are made without adequate security, they involve a high element of risk, so a high rate of interest is charged.

2. Compensation for Inconvenience:

A lender lends only by saving, i.e., by restricting consumption out of his income, which obviously involves some inconvenience which is to be compensated.

A similar inconvenience is that the lender may not be able to get his money back as and when he may need it for his own use. Hence, a payment to compensate this sort of inconvenience may be charged by the lender.

Thus, the greater the degree of inconvenience caused to the lender, higher will be the rate of interest charged.

3. Payment for Management Services:

A lender of capital funds has to spend money and energy in the management of credit. For instance, in the lending business, certain legal formalities have to be fulfilled, say, fees for obtaining moneylender’s license, stamp duties, etc. Proper accounts must be maintained. He has to maintain a staff as well.

Thus, for all these sorts of management services, reward has to be paid by the borrower to the lender. Hence, gross interest also includes payment for management expenses.

4. Compensation for Changing Value of Money:

When prices are rising, the purchasing power of money declines over a period of time, and the creditor loses. To avoid such a loss, a high rate of interest may be demanded by the lender.

Usually, the net rate of interest is the same everywhere. In economic equilibrium, the demand and supply for capital determines the net rate of interest. But, in practice, gross interest rate is charged.

Gross interest rates are different in different cases at different places and different times and for different individuals.

Rates of Interest:

Various rates of interest are charged on the different types of loans by various institutions. The following are the main reasons for the disparities of gross interest rates:

(i) There are different types of borrowers. They offer different types of securities. Their borrowing motives and urgency are different. Thus, the risk element differs in different cases, which have to be compensated.

(ii) The money market is not homogeneous. There are different types of lenders and institutions specialising in different types of loans and the loanable funds, and the loanable funds are not freely mobile between them. The ideals of these institutions are also different.

(iii) Duration of loans also varies. Long-term loans have higher interest charges than short-term ones.

(iv) Duration of supply conditions of capital funds are also different in different countries; so different countries have different interest rates. Further, inflationary conditions differ in different countries.

Interest, in the real sense, is the return of the real capital assets employed for production processes.

Why interest is paid is a very baffling question to answer. Different economists have offered different explanations or theories on the origin and determination of the equilibrium rate of interest.

We shall, however, examine four important theories of the determination of the rate of interest:

1. The Classical Theory;

2. The Loanable Funds Theory;

3. The Keynesian Theory – or the Liquidity Preference Theory; and

4. The Neo-Keynesian or Modern Theory.

The fundamental difference between the first two traditional theories (i.e., the classical and the loanable funds theories) and the Keynesian theory of interest lies in the economics of full employment and the economics of less-than-full employment.

The Keynesian version of the theory of interest radically differs from the classical explanation of the nature and determination of the rate of interest.